What is a home equity loan and how does it work?

Written by: Erica Gellerman, CPA
• Updated •8 min read • Leer en español
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In a Nutshell

A home equity loan is a type of loan that lets you borrow a lump sum of money by tapping the equity in your home while using your home as collateral to secure the loan. While it may help you access money, there’s a big risk to consider: If you can’t repay your loan, you could lose your home.
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Whether you need to fix a leaky roof or borrow money for your child’s education, if you have equity in your home, you might consider a home equity loan.

A home equity loan lets you access the existing equity in your home — or the difference between what you owe on your mortgage and what your home’s value is. You may sometimes hear this loan option referred to as a second mortgage.

Unlike with a traditional first mortgage that you use to buy a home, you can use the money borrowed with a home equity loan to help you pay for major expenses, even if it’s not related to your home.

While this can make a home equity loan sound appealing, it’s important to remember that it’s a secured loan — meaning you’re using your property as collateral. Just like your original mortgage, if you can’t repay your loan as agreed, the lender could foreclose on your home.

How does a home equity loan work?

A home equity loan lets you tap into the equity that you’ve built in your home. Generally, you can borrow up to 85% of the equity you have in your house You can use the money that you borrow for more than home-related expenses.

When you apply for a home equity loan, a lender must give you important loan disclosures, such as the amount you can borrow, the interest rate — including whether it’s a variable interest rate — and any fees. Common fees in your closing costs can include an origination/underwriting fee, appraisal fee, document prep fees, broker fees and application fees.

Home equity loans are for a lump sum of money and usually come with a fixed interest rate. Be sure to pay close attention to any fees that the lender charges — these can vary from lender to lender, so it’s smart to shop around for the best loan terms for your situation.

Depending on how you use the money, the interest you pay may be tax deductible. If you use the money to buy, build or substantially improve the home securing the loan, you may be able to deduct those expenses.

What can I use a home equity loan for?

You can use the funds from a home equity loan or many purposes. Some examples include debt consolidation, major purchases, emergency expenses, weddings or home renovations. If you decide to use a home equity loan for renovations or upgrades on the house that’s securing the loan, the interest you pay may qualify for the mortgage interest rate tax deduction.

How much can I borrow with a home equity loan?

Your lender will determine how much you can borrow by looking at a number of different factors, including your income, debt-to-income ratio, the value of your home and your credit history. Lenders want to make sure you have enough income and aren’t paying off too much debt before lending to you.

The maximum amount a lender will usually approve is 85% of the equity in your home.

For example, say your home’s appraised value is $300,000 and you owe $200,000 on your mortgage. The maximum amount you’ll likely be approved for is $85,000. Here’s how to calculate that, assuming you don’t have any other liens on your home.

  • Home appraised value: $300,000
  • Mortgage loan balance: $200,000
  • Equity in your home: $100,000
  • Potential home equity loan amount: $85,000 (85% of the equity you have in your home)

You’ll probably need to build up a good amount of equity in your home before you’re able to borrow a large amount of money.

How do I repay a home equity loan?

If you take out a home equity loan, you’ll begin making monthly loan payments in addition to your regular mortgage payments. Repayment is very similar to how a traditional mortgage is repaid. Your loan payments will go toward principal (the amount borrowed) and interest (your charge for borrowing money).

Are home equity loans a good idea?

Home equity loans may not be a good idea for everyone, but for some situations you might want to consider it. Here are a few.

You’ve built up enough equity in your home

Because the amount of money you can borrow is tied to the amount of equity you have in your home, you’ll want to ensure you’ve built up enough equity before applying for a loan. Remember, most lenders only let you borrow up to 85% of the equity in your home. So the equity you’ve acquired is an important factor to consider.

If you made a larger down payment when you bought your home, you’ll likely have more equity.

You qualify for a favorable interest rate

Lenders look at more than just your home equity when deciding how much to lend you and at what interest rate. Your lender will assess your ability to repay the loan and can base your interest rate based on factors such as income, debt and credit history. A lower interest rate could mean you pay less over the life of the loan.

You can handle the increased monthly payments

When you borrow more money, you’ll have more to repay each month. If you can handle the increased monthly payments in your budget, a home equity loan may help advance your financial goals.

But remember, if you aren’t sure you’ll be able to handle the monthly payments, a home equity loan is a risky idea. If you’re not able to make the larger monthly payments, there’s a chance you could lose your home to foreclosure.

Pros and cons of home equity loans

If you’re considering a home equity loan, make sure you think about the advantages and disadvantages. 

Pros of home equity loans

  • Lower interest rates — A home equity loan is secured with your house, making it a lower-risk loan for lenders (but higher risk for you). This means that home equity loans can have lower interest rates compared to unsecured loans or credit cards. 
  • Fixed monthly payments — Home equity loans have fixed monthly payments over a set number of years, which can be helpful for budgeting.  
  • Tax advantages — Depending on the year you got your loan and what you use it for, the interest you pay may be tax deductible. 

Cons of home equity loans

  • Closing costs — Not all lenders will charge fees for a home equity loan, but typical closing costs range from 2% to 6%. 
  • Risk of foreclosure — A home equity loan uses your home as collateral to secure the loan. If you default on your payments, your lender could foreclose on your home. 
  • Long process — It’s possible that you may need an appraisal on your home to see what it’s worth. From application to closing, a home equity loan may take a month or more until you can get the funds.

What are some other financing options?

If you need extra money, there are other financing options that may work better for you.

HELOC

Home equity lines of credit, or HELOCs, also let you borrow against your home equity, but they work differently. Rather than borrowing a lump sum of money for a set period of time, a HELOC functions more like a credit card. You’re given a credit limit and can draw on that line of credit when you need it, rather than getting the money upfront. You’ll make payments on how much you actually borrow, not how much you’ve been approved to borrow.

Most HELOCs have a variable interest rate that fluctuates based on an index like the prime rate. That means you could pay more money if your rate increases.

HELOCs still require you to use your home as collateral, so you could end up losing it if you can’t keep up with the monthly payments and end up defaulting on the loan.

You may have a minimum or maximum withdrawal requirement on your account, and you may have a draw period when you’re able to withdraw funds. You may have to repay your outstanding debt all at once after the draw period ends or over a period of time.

Cash-out refinance

If you’re looking for another way to access the equity in your home, a cash-out refinance may be an option. During the mortgage refinancing process, you’ll pay off your existing mortgage with a new one. People may refinance to get a lower-rate loan, switch from a variable to a fixed interest rate or change the length of their mortgage.

A cash-out refinance lets you refinance your home for more than what you currently owe on your loan. The difference can be given to you as a lump sum.

Unsecured personal loan

If you don’t want to use your home as collateral for a loan, you might consider an unsecured personal loan. With an unsecured loan, you can borrow money without using any collateral for the loan. But because these are seen as a riskier loan for the lender to make, they often come with higher interest rates.

What’s next?

While a home equity loan can seem like an attractive way to access cash, you’ll want to be sure it’s the right option for you because it does come with some risks. It’s a good idea to consider other loan options and shop around with different lenders for the best rate for you.

Check your credit scores and reports to get a sense of whether you might be able to qualify for a loan at attractive terms. You may want to work on improving your credit before you apply.

And before you take out a loan of any kind, take some time to think through why you need a loan and how you’ll repay the money. You don’t want to borrow more than you can afford to repay.

FAQs about home equity loans

What’s the difference between a home equity loan and a HELOC?

With a home equity loan, you receive the funds all at once and repay the loan at a fixed amount over a set number of years. With a HELOC, you don’t receive all of the funds at once. Similar to a credit card, you have a credit limit and use the funds as you need them. You only repay what you borrow.

How long do you have to repay a home equity loan?

How long you have to repay your home equity loan depends on your particular lender. But your loan could have a repayment term of up to 30 years.

Are home equity loans tax deductible?

Whether the interest is tax deductible depends on how you use your home equity loan funds and when you got your home equity loan. For tax years 2018 through 2025, home improvements on the home securing the loan may make the interest you pay tax deductible. For tax years before 2018 and after 2025, interest may be tax deductible regardless of how you use the loan funds.

About the author: Erica Gellerman is a personal finance writer with an MBA in marketing and strategy from Duke University. She’s also the founder of The Worth Project: a weekly money newsletter you actually want to read. Her work has b… Read more.