What is a Home Equity Loan? Your Comprehensive Guide

Quick insights

• A home equity loan, often considered a second mortgage, allows you to borrow against the equity you have accumulated in your property.
• Homeowners commonly use these loans for major expenses such as home renovations, funding education, debt consolidation and investments. Lenders usually require a substantial amount of equity in the home, stable income, good credit history and low debt-to-income ratio.
• While a home equity loan provides a lump sum with fixed interest rates, Home Equity Lines of Credit (HELOCs) offer flexible borrowing with variable rates, which could be suitable for ongoing expenses.

Are you looking to unlock the value of your home? A home equity loan might be a good solution. This financial tool allows you to borrow against the equity you’ve built, providing a way to access cash for big expenses like home renovations, education, debt consolidation or real estate acquisition. With typically lower interest rates than personal loans or credit cards, a home equity loan could be an attractive option for individuals looking to make the most of their property investment. Let’s dive into the process and what you may want to consider before tapping into your home’s equity.

How does a home equity loan work?

Before borrowing against your home, it might be wise to understand the home equity loan process and how these loans work. Here’s a breakdown of how the process typically works:

• Understanding home equity: Home equity is the difference between your home’s current market value and the remaining balance on your mortgage. For example, if your home is worth $300,000 and you owe $200,000 on your mortgage, your equity is $100,000.
• Home equity loan as a second mortgage: A home equity loan is often called a second mortgage because it is secured by your home, alongside your primary mortgage. If you default on the loan, the lender can claim your property.
• Lump-sum payment: Unlike a HELOC, which allows for flexible borrowing, a home equity loan provides a lump sum payment upfront.
• Determining borrowing amount: Loan providers typically allow you to borrow up to 80% of the property’s value, minus what you owe on your mortgage. For instance, if your equity is $100,000, you could potentially borrow $80,000. Your credit score, income and debt-to-income ratio will also impact how much you can borrow.
• Applying for a home equity loan: Compare rates, terms and fees from different lenders to find the best deal. Loan providers will evaluate your financial situation, credit history and home’s value. This may involve a home appraisal.
• Repayment terms: Most home equity loans have fixed interest rates, meaning your monthly payments remain the same over the life of the loan. Typical repayment terms range from 5 to 30 years. A longer term results in lower monthly payments but higher total interest costs. Your payments will include both principal and interest.
• Closing costs and fees: Similar to a conventional mortgage, a home equity loan may come with closing costs, which could include appraisal fees, title insurance and origination fees. These costs can be significant, so factor them into your decision.
• Using the funds wisely: Many homeowners use the funds for home improvements, debt consolidation or emergency expenses. It might be a good idea to use the money for investments that could increase your home’s value or improve your financial situation.

Home equity loan requirements

Home equity loans, like other financing options, come with certain requirements. Lenders will typically look for:

• Adequate home equity: Lenders typically prefer homeowners who have built up a significant amount of equity in their home already. Lower equity means less to borrow against, too.
• Stable income: As with any loan, lenders want to see consistent income that suggests you’ll be able to repay the loan.
• Good credit history: While not always mandatory, a good credit history can be beneficial.
• Low debt-to-income (DTI) ratio: A lower debt load compared to your income indicates to lenders you could effectively handle new debt.

What you can use your home equity loan for?

Home equity loans can be used in various ways. Homeowners commonly use funds for:

• Home improvements: You can use the funds to upgrade your kitchen, bathroom or add extra space. These improvements could enhance the value of your home.
• Debt consolidation: Combine multiple high-interest debts, such as credit cards, into one loan with a lower interest rate, potentially saving on interest payments.
• Major expenses: Cover large expenses like buying a car without taking on high-interest loans.
• Investment opportunities: Use the loan to invest in stocks, real estate or a business venture. Please keep in mind that this may come with inherent risks.
• Travel and experiences: Finance a dream vacation or travel experiences that might otherwise be out of reach.

Pros and cons of a home equity loan

Home equity loans, like other financial products, come with their own set of potential advantages and disadvantages. Let’s look at what some of these might be to help you make a more informed decision:

Advantages of a home equity loan

• Fixed interest rates: Home equity loans typically come with fixed interest rates, meaning consistent monthly payments throughout the loan term.
• Flexible use: The funds from a home equity loan can generally be used for various purposes.
• Potential tax deductions: In some circumstances, the interest paid on a home equity loan may be tax-deductible. Speaking with your lender and a qualified tax professional can provide clarity as to whether this may be the case for your prospective home equity loan.
• Lump sum disbursement: Homeowners generally receive the loan amount all at once.

Home equity loan disadvantages

• Your home is collateral: Since the loan is secured by the home itself, there’s the potential risk of foreclosure if the loan isn’t repaid as agreed.
• Additional debt: Taking out a home equity loan means more debt, requiring additional financial management.
• Closing costs: As with an initial mortgage, a home equity loan may come with closing costs and other fees.
• Reduced equity: Borrowing against it reduces the total amount of equity you have in your home.

How to get a home equity loan

While the specifics vary by situation, the process generally follows a few key steps:

• Picking a lender: Shopping around and comparing a variety of lenders can help you identify the one best suited for your needs and financial situation.
• Applying: Once you’ve chosen a lender, the next step is to submit your loan application. You will be asked for certain financial documents, details about your home and other relevant information.
• Appraisal: In some cases, lenders may require an appraisal to determine the current market value of your home.
• Approval and terms: If approved, you’ll be presented with loan terms, home equity loan rates and other important details. It’s then up to you to accept these terms.

Alternatives to home equity loans

While home equity loans are typically a popular option for accessing the equity in your home, there are alternative financing methods to consider:

• Cash-out refinancing: Replaces your existing mortgage with a new one for a higher amount. It allows you to access the difference in cash. This option may offer lower interest rates than home equity loans. It combines the first mortgage and cash-out portion into a single loan.
• HELOC: Functions like a credit card, allowing you to borrow against your home’s equity as needed. This option typically offers variable interest rates and provides flexibility to draw funds over time for various expenses.

Home equity loan vs. cash-out refinance

There are a few ways for homeowners to tap into the equity they’ve built in their property. Two common ways are: Home equity loan and cash-out refinance. A home equity loan functions as a second mortgage and offers a lump sum payment with fixed interest rates. The repayment terms are typically fixed and predictable. A cash-out refinance places your original mortgage with a new, larger mortgage. This may result in a lower interest rate compared to a home equity loan. It combines your existing mortgage and cash-out into one payment.

Home equity loan vs HELOC

When deciding between a home equity loan and a HELOC, it’s important to understand the differences. Here’s a comparison to help you decide on the right option:

• Home equity loan: This loan option provides a lump sum of cash and features fixed interest rates and predictable monthly payments. It is ideal for specific large expenses, like home renovations or your child’s college education.
• HELOC: This loan functions like a credit card, allowing you to borrow on an as needed basis. Typically, this loan type has variable interest rates, meaning payments can fluctuate.  You only pay interest during the draw period, followed by a repayment phase with both principal and interest. It is ideal for ongoing expenses such as gradual home improvement projects.

In summary

A home equity loan lets you borrow against the equity you’ve built in your home, possibly with more favorable terms than a more traditional loan. It’s important, however, to keep in mind that you are borrowing against the equity you’ve built in your home and that failure to repay your home equity loan may have implications for your homeownership. Speak with a qualified home lending professional to learn more about how a home equity loan might prove valuable to you.

Home equity loan FAQs

1. Is a home equity loan a second mortgage?

Yes, a home equity loan is sometimes referred to as a second mortgage. This is because it allows homeowners to borrow against the equity in their homes, similar to how a primary mortgage functions.

2. Can I get a home equity loan with bad credit?

It is possible to get a home equity loan with bad credit but may be more challenging. Lenders typically assess your creditworthiness before approving home equity loans. A higher credit score might lead to better loan terms and interest rates. Other factors, such as the amount of equity you have in your home and overall financial situation, can also influence a lender’s decision. Speak with a home lending professional to better understand your options.

3. Are home equity loans a good idea?

Whether a home equity loan is a good idea largely depends on your personal goals and unique financial circumstances. A home equity loan can potentially offer a lower interest rate compared to other types of loans and can be used for various purposes. However, since your home serves as collateral, there’s additional risks to consider if you were to default on the loan.

4. Do you need an appraisal for a home equity loan?

Yes, most lenders require a home appraisal for a home equity loan to determine the current market value of your home. This helps them measure the amount of equity you have — one of the key factors in the loan amount you might qualify for.

Have questions? Speak to our Home Lending Advisors for details on other products that Chase may offer.