Solved! How Does a Home Equity Loan Work?

Your home is your biggest investment, and you’ve worked hard to pay down the mortgage. That equity can help you finance home improvements or education plans without opening up new, expensive lines of revolving credit. But how does a home equity loan work, exactly?

By Meghan Wentland | Published Nov 18, 2021 11:54 AM

How Does a Home Equity Loan Work

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Q: We have decided to renovate our home to make it into our dream house rather than move, but it will be a pricey renovation. Can we use the equity we’ve developed to cover that cost?

A: You can! Having put in the hard work and discipline to build equity in your home is a great feeling, and while getting that much closer to paying off the mortgage is exciting, it also means that you have access to a pool of funds that you can borrow from to finance your renovation at a great rate. You can also use it to finance non-home-related expenses, such as a child’s college education, medical bills, and other large expenses. Alternatively, you can use the equity as a kind of emergency fund, rather than keeping a credit card open for that purpose. How does a home equity loan work? Essentially, you apply for a loan using the difference between your home’s value and the amount you still owe on your mortgage as the value of your collateral, and you borrow against it. The rates are usually lower than those on other kinds of personal loans, and you can pay yourself back over time. The home equity loan can be paid out in a lump sum, where you’ll make regular monthly payments until you’ve paid off the whole loan, or taken as a home equity line of credit, in which you take the loan but only draw on the funds when, and if, you need them, making payments on the money you’ve actually taken out of the pool.

Home equity is the portion of your home you “own”—essentially, the amount of your mortgage you’ve paid off.

How Does a Home Equity Loan Work

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When you buy a home, you don’t really “own” the home until you’ve paid off your mortgage. Presumably you put down some money as a down payment. When you sign your mortgage papers and take the key to your new house, you own exactly the percentage of the home that you put down—unless you default on your mortgage, in which case the bank will likely take some of that in back charges and fines. As you pay your mortgage each month, however, the percentage of your home that you have actually paid for will increase, slowly at first, and then faster as you advance through the years of mortgage payments and start paying more principal and less interest. Each payment buys you a little more of your home.

The percentage of your home that you have completed payment for is called equity. This is the pool of money that a home equity loan allows you to borrow from. In the past, this kind of loan was referred to as a “second mortgage,” because a home equity loan allows you to borrow money against the portion of your home that you own while the remainder of the home is still owned by the lender of your “first,” or main, mortgage.

Equity is also affected by the current appraised value of your home. If you’ve faithfully been paying your mortgage for 15 years, it’s possible that the value of your home has gone up (or down) significantly since you bought it. An appraiser can tell you the market value of your home, and that value is the equity that you have in your home. For example, say you took out a mortgage of $200,000 on a home with a value of $225,000. You’ve been paying for a number of years, and the balance left on your mortgage is $150,000. Based on the purchase price, you have $75,000 in equity: the difference between the $225,000 value and the $150,000 you still owe. But perhaps the real estate market in your area is hot and houses are in high demand. If an appraiser tells you that the current value of your home has grown to $300,000, your equity is now $150,000: the difference between the current value and what you owe.

The amount of money that you can borrow in a home equity loan is limited by the amount of equity you have built in your home. The appraised value minus the amount you still owe on your first mortgage is the amount of equity you have in your home: that’s the pool of money your home equity loan will be drawn from.

How Does a Home Equity Loan Work

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Your home equity can be converted into a loan to fund almost anything from home improvements to a child’s college education.

Unlike some kinds of loans, money borrowed from your equity is not limited to specific purposes, nor will you have to account for what you spent it on. If you have a backup of bills after a long illness or temporarily reduced income, you can use the money to pay off your debts and make one monthly payment (likely at a much lower rate) instead of keeping track of a large stack. Medical expenses, wedding costs, college tuition, and room and board payments are fair game, as are payments to contractors, supply bills, and temporary housing during a home renovation. You can even use the funds to pay for a long-awaited vacation. Rates on home equity loans are usually quite favorable compared to other personal loans, because you have already successfully paid down at least a portion of your mortgage and have the home itself to use as collateral. Just remember that the loan still has to be paid back—regardless of what you spent the money on—and that if you can’t pay it back, you’ll stand to lose your home.

To get a home equity loan, you must build up equity first.

When you buy a home, the purchase price is met with two components: a down payment and a mortgage loan. The portion of the price covered by each of these parts varies based on the loan program through which the mortgage is acquired and the amount of available cash you have to put down. Each month, when you make your mortgage payment, the money goes in several directions: Some goes to an escrow account from which your mortgage company pays your local property taxes and homeowners insurance premium, some goes toward the interest you owe on the mortgage, and some goes toward the principal balance on your loan. In the early days of a mortgage, many homeowners are distressed to see what a small percentage of their monthly payment actually works to pay down the balance. Mortgages are amortized, which means there’s a formula that breaks down this amount. At the beginning of the repayment period, a much larger percentage of the payment is applied to interest than to the principal. As time goes by, this ratio begins to shift, so that at the end of the mortgage the payment is almost exclusively applied to the principal. This is so that the lender makes sure they get their cut of interest on the risk they took in lending to you; if they apply your whole payment to your principal and you choose to refinance or pay off the mortgage early, they won’t get as much interest out of you. Amortizing the loan so that the front-end payments are interest-heavy protects the lender.

Unfortunately, what it also means is that it’s going to take a while to build up equity. You immediately have equity in the amount of cash that you put down as a down payment. That money bought you a “piece” of your home that the bank doesn’t own. But the equity that you build by making regular monthly payments can take some time to accrue. Over time, you can build equity faster (and, at the end of your mortgage, save some money in interest) by paying extra money on your mortgage payment and asking that it be applied to the principal. Not all loans permit this early or extra payment, but when you have a little extra cash on hand, it can be helpful if your lender does allow this.

In order to take out a home equity loan or line of credit loan, most lenders will require that you have at least 15 to 20 percent equity, meaning that your mortgage balance is equal to or less than 80 to 85 percent of your home’s appraised value. If you don’t have at least that much equity, most lenders feel that additional debt will leave you dangerously over-leveraged, without enough collateral, and that with the fees and costs associated with closing the loan you may end up with very little actual cash available in your loan.

How Does a Home Equity Loan Work

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A simple calculation can allow you to know how much you can borrow.

Financial experts advise that your total home debt, or the amount that you owe on your home including the original mortgage plus any home equity loan or HELOC (Home Equity Line Of Credit), should not equal more than 85 percent of the value of your home. If it’s been a while since you last had your home appraised, this might be a good first step; your home’s value may well have changed while you were busy building equity, and you may be pleasantly surprised by how much it’s worth. Once you know the value, you can multiply the number by .85 to establish the maximum amount of debt most banks will allow you to take on the house. Subtract the amount you still owe on your mortgage or any other home loans, and you’ll arrive at the amount you can request to borrow through a home equity loan. There are a number of home equity calculators available online that can give you a rough idea of how much equity you have, but for precise numbers you’ll need a current appraisal.

A word of caution, however, on automatically taking the maximum amount you can: Your home is the collateral for this new loan and for your mortgage. Leveraging 85 percent of that value into money that you’ll need to pay back can be a risk, as rates, values, and finances can rapidly change with the market. Maximizing your home’s value in a loan means that a shift in the real estate market could leave you owing more than your home is worth, and one lost job could mean missed payments that allow the bank to foreclose on your home and leave you with no equity at all. This calculation will tell you what you can borrow, but it’s up to you to consider your finances and savings and decide what you should borrow.

To get approved for a home equity loan, borrowers must meet certain requirements.

Just like when you apply for a mortgage, you’ll need to demonstrate to your lender that you’re a good financial risk for them to take. This means you’ll need to follow nearly the same process that you did to take out your first mortgage. First, you’ll want to check up on your credit score and correct any errors in the report. Your FICO score will need to be at least 620 to qualify for most home equity loans, and even higher for optimal rates.

Once you’ve acquired your credit report, you can calculate your debt-to-income ratio. This is the amount of money you owe toward debt payments each month compared to the amount of money you earn each month. The percentage that goes toward your debt payments should not be more than 43 percent of your income. If the current percentage is more than 43, you’ll want to work toward paying off some of that debt before you apply for a home equity loan. Lenders want to make sure that you don’t overextend yourself and default on the money you owe them, because it’s expensive to foreclose on a home to recoup their loss. They would prefer that you continue making regular payments with interest, so they’ll want to make sure you can really afford to borrow.

You’ll need to produce documentation of your income and assets in order to apply for a home equity loan as well. Tax forms, pay stubs, bank statements, and your current mortgage documents are all reasonable documents for your lender to request so that they can comfortably loan you money. These documents can also result in a more affordable interest rate on your loan, as lenders can offer better rates to more qualified borrowers who can document their financial situation.

A home equity loan is not the same as a HELOC, or a home equity line of credit.

Both a home equity loan and a home equity line of credit, or HELOC, are borrowed from the pool of equity you’ve built in your home. But there’s a substantive difference between the two. In a home equity loan, borrowers request a specific amount of their equity as a loan. The loan is disbursed in one sum, to be deposited in the borrowers’ regular bank account and spent as needed. Payments begin immediately on the full amount borrowed until it is paid off. Terms vary, but there’s a set number of months required for the payoff, and occasionally a larger balloon payment at the end of the term.

A HELOC operates a bit differently. The borrower requests that a certain amount of their equity be made available to them. If the request is approved, that money becomes available to them, but is not immediately disbursed—it sits there in an account until the borrower withdraws some of it and operates as a line of credit loan. Therefore, no real payments are required immediately, because until a withdrawal is made, the borrower technically hasn’t received any of the funds. These accounts will have a specific limit on how often and for how long the borrower can withdraw money and may include an annual maintenance fee or transaction fee when money is withdrawn. After money is withdrawn, the borrower will begin making payments over a set period of time, but only on the money that has been withdrawn and not on the full amount of the available equity. These loans can be quite useful when you’ll need money at various points over a long period of time. For example, if you’re planning to pay for college tuition with a HELOC, you can request a line of credit in the total amount you’ll need at the beginning. As each semester’s payment comes due, you can withdraw that amount from the account to pay the bill (usually at a much better rate than a private education loan) and then begin repayment only on that amount. This allows you to space out the repayment more gradually over time, rather than making large payments on the total amount right from the start.

How Does a Home Equity Loan Work

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There are pros and cons to getting a home equity loan.

Home equity loans have a lot of benefits: They are offered at rates lower than other personal loans, may be easier to secure than other personal loans, and they simplify repayment of other debt into one consolidated amount. But there are some things to watch out for that may not be immediately apparent.

If you’re taking a home equity loan to do home improvements, there are some additional things to take into consideration. It’s exciting to upgrade your home and choose some special elements that make it truly yours. You’ll expect to see an increase in the overall value of the home as a result of the improvements and upgrades, and this is almost always the case. It’s key to consider the average value of homes in your area as you make these calculations, however. Believe it or not, it’s possible to “over-improve” your home for the market to a point where the real value of the home is much higher than buyers will pay to live in your neighborhood. In that case, you won’t get the return on your investment. This might not seem like a big deal, especially if you’re improving with the intent of remaining in the home for several decades and want it to suit your own lifestyle rather than someone else’s idea of value. However, you may find yourself in a bind if your life circumstances change and you need to sell your home unexpectedly. When you sell a home with a mortgage and a home equity loan, usually the payoff of your mortgage is wrapped into the home sale, and that can also be the case with a home equity loan—unless you owe more on the home equity loan than the sale price will cover. Buyers’ lenders will not approve mortgages for more than the home is worth on the market, so you could be stuck trying to come up with the money to pay off your home equity loan in order to sell the house. Carefully consider the value of your home balanced against how much debt you have riding against it so that you don’t over-improve your home.

Another consideration is the fees and costs that come along with home equity loans and HELOC. If you are processing your home equity loan through the same lender that holds your regular mortgage, some of the fees may be reduced, and some banks offer low- or no-fee home equity loan processing. Most home equity loans, however, are treated the same way as a mortgage application is, because the house is the collateral for the loan and the lender has to make sure it can collect that collateral in the event that you default. They will likely expect you to pay an application fee, title search fee, and appraisal fee, and potentially other filing fees, plus you’ll need to pay attorneys’ fees and other assorted closing costs. These can really mount up quickly, and especially if you’re only planning to take a small loan, they may negate the value of the loan itself.

Finally, it’s key to remember that you will be adding what is essentially a second mortgage payment on top of the one you’re already making. This may absolutely be easier than keeping track of and paying a stack of smaller bills each month. Your lender will prevent you from borrowing more than they think you’ll be able to afford. But here’s the thing: If you unexpectedly fall on hard financial times and have trouble paying your bills, being late on your stack of smaller bills will cost you fines and fees, while repeatedly being late on two mortgages can cost you your home. There’s a lot at stake when you borrow heavily against your home. You want to shop around, choose a lender that you trust, and decide how much you need to borrow to accomplish the projects you have in mind and not take as much as you possibly can just because you can.

Once you’ve found a trustworthy lender and made decisions about how much to borrow, enjoy working on your home improvement project or paying for your wedding, and celebrate the discipline with which you built enough equity in your home for you to use!