Homeownership allows you to build equity—and that can be a great way to build wealth over time.
Equity is the market value of your home, minus any outstanding liens on the property. As you repay your mortgage over time, and the value of your home grows, your equity will, too. And should you decide to sell your home, that equity directly translates into profits.
If you don’t want to sell your home, but you do want to leverage its value to pay for other things, you can take out a home-equity loan.
What is a home-equity loan?
A home-equity loan allows you to borrow against the market value of your house and receive a lump-sum payment in return. Your home will serve as collateral for the loan if you’re unable to repay it.
Here are the key elements of this type of loan:
- Home-equity loans typically charge fixed interest rates. With a fixed rate, your payments will remain the same for your entire loan term.
- The length of home-equity loans can vary. Lenders may offer five-, 10-, 15-, 20-, and even 30-year home-equity loans.
- You’ll have a second monthly payment. Home-equity loans don’t replace your existing mortgage like a refinance does. Instead, they’re a second loan entirely that will be repaid separately each month. So you’ll have two monthly payments moving forward until you pay off the home-equity loan.
- These loans charge higher interest rates than traditional mortgage loans. They are considered riskier, so lenders charge higher rates—typically, between 5% and 7%.
With home-equity loans, you can use the funds for any purpose.
“Consumers take out home-equity loans for many different reasons, often using the funds to cover large expenses—like renovations,” says Heather Harmon, head of Opendoor Finance. Leveraging your home’s equity to make improvements to your home is a smart move, she says, as it can “increase the value of your home over the long term,” which will ideally boost your equity even more.
Homeowners also often use home-equity loans for education costs, medical bills, and consolidating debt. “Home-equity loans generally have lower interest rates compared to non-mortgage borrowing—like credit cards,” Harmon says. “Using a home-equity loan to consolidate debts into one, more manageable monthly payment—plus at a better rate—can provide some financial relief.”
How does a home-equity loan work?
A home-equity loan turns a portion of your equity into cash. Typically, lenders will allow you to tap anywhere from 80% to 90% of your total home equity—across all mortgage loans. If your home is worth $500,000, you could access up to $450,000 (90%) through a home-equity loan, minus any balance remaining on your current mortgage.
The process of applying for a home-equity loan is the same as that for a traditional mortgage loan. You fill out an application with a lender, provide financial documentation, and, in some cases, pay closing costs (not all lenders require this). Then you sign your closing papers and, at least three days later, receive your money.
From there, you simply repay your home-equity loan in monthly installments as you do your existing mortgage loan.
What are the requirements for taking out a home-equity loan?
The exact requirements for a home-equity loan depend on your lender. But generally, “home-equity loans have similar qualifications to mortgages,” says Jon Giles, head of consumer direct lending at TD Bank. “The lender will primarily focus on three areas: the borrower’s credit score, their debt-to-income ratio, and the loan-to-value ratio on the home.”
Here’s a look at the requirements you may need to meet for a home-equity loan:
- Debt-to-income ratio (DTI): This is how much of your monthly income your debt payments (including the new home-equity loan) take up. You will usually need a DTI of 45% or lower.
- Loan-to-value ratio (LTV): Your LTV is how much of your home’s value your loans account for. Most lenders will allow you to have between an 80% and 90% LTV—meaning your home-equity loan and main mortgage loan can account for no more than 90% of your home’s value.
- Equity: Equity is the difference between your home’s value and your mortgage balance. You can expect a requirement of at least 10% to 20% equity to qualify for a home-equity loan.
- Credit score: You’ll need at least a 620 score to qualify, though Harmon says some lenders prefer a 700 or higher.
“Although requirements vary, generally, lenders are looking for a low debt-to-income ratio, good credit, and a reliable payment history—as well as a sufficient percentage of equity in your home,” says Rob Heck, vice president of mortgage at Morty, an online mortgage broker.
Because each lender has its own requirements, loan products, and fees, you should compare at least a few options to determine what you qualify for and what’s available to you.
“Shopping around is key here,” Heck says. “There is a wide range of offerings, and checking banks, credit unions, and online providers should give you a good sense of what is out there.”
Pros and cons of home-equity loans
Home-equity loans certainly have benefits. They allow you to get a large lump sum of money when you need it, and you can use the funds for any purpose.
“The benefit of a home-equity loan is that you can use the money for anything—whether it’s paying for a remodel or something entirely unrelated, like a down payment on a car, for a wedding, or medical expenses,” Heck says.
These types of loans also come with consistent, reliable payments and lower interest rates than other financial products. In some cases, the interest on these loans may even be tax-deductible.
“Over the past few years, home equity has reached record highs, making it a potential advantageous option to tap into,” Heck says. “Utilizing a home-equity loan is a great opportunity for many people to borrow a large amount of money at a lower rate than you may get with something like a personal loan or credit card.”
Despite this, home-equity loans aren’t fit for everyone. For one, they put your home at risk. Since your home is used as collateral, you could be foreclosed on if you don’t make your payments.
There’s also the chance, should home values decline in your area, that your mortgage balances will outweigh your home’s value. This is called being “upside down” on your mortgage.
“You’re leveraging equity in your home, but adding an additional payment at a higher rate,” Harmon says. “If your home value goes down, you could end up owing more than your home is worth.”
Frequently asked questions
What’s the difference between a home-equity loan and a HELOC?
Home-equity loans and HELOCs—or home-equity lines of credit—are similar, but not quite the same. While both let you borrow against your home equity, there are a few key differences.
With home-equity loans, you get a lump-sum payment. Then you repay the money via fixed monthly payments over an extended period (up to 30 years, in some cases).
HELOCs, on the other hand, give you a line of credit to pull from, similar to a credit card. You can then withdraw money as needed for the next 10 or so years. Interest rates tend to be variable on HELOCs, so your interest rate and payment can change over time.
A home-equity loan is a good option for those who desire the consistency of a fixed rate and a set repayment schedule, while a HELOC provides the flexibility to use funds as needed.
Is home equity the same as a mortgage?
A home-equity loan is a type of mortgage loan. Technically, it’s a second mortgage, meaning it’s a lower priority than your main mortgage. If you were to default on your loans, the lender on your first mortgage would have the rights to the home and could sell it off to recoup their losses. After that debt is satisfied, any remaining funds would go to your home-equity lender.
This makes home-equity loans a riskier bet for lenders, and it’s why they usually have stricter requirements than other mortgage loans. It’s also why they have higher interest rates.
Can you pull equity out of your home without refinancing?
A home-equity loan is one way to pull equity out of your home without refinancing. HELOCs are another option, or you could explore an equity sharing agreement. These let you sell off a portion of your home’s future equity in exchange for a lump-sum payment. You usually repay the money when you sell your house later on.
EDITORIAL DISCLOSURE: The advice, opinions, or rankings contained in this article are solely those of the Fortune Recommends™ editorial team. This content has not been reviewed or endorsed by any of our affiliate partners or other third parties.