How to Choose a Home Equity Loan

Homeownership is one of the largest sources of wealth for Americans. If your home’s value goes up and you pay the mortgage on time, your ownership share—also called equity—increases, turning it into a veritable piggy bank.

Thanks to years of rising home prices, Americans are now sitting on billions in home equity. As of the fourth quarter of 2023, the typical homeowner had $298,000 in equity, according to data provider CoreLogic. U.S. homeowners gained $1.3 trillion in equity between the end of 2022 and the end of 2023 alone.

Home-equity loans are one way you can turn that equity into cash. Here’s how these loans work, how to shop for one and risks you should be aware of before moving forward.

What is a home-equity loan?

Home equity is the difference between the value of your home and the amount you owe on your mortgage (or mortgages). Typically, your equity will go up each time you make a payment. If home values rise, your equity will also get a boost.

Picture an old-fashioned scale—when you first buy a home, you probably have more debt than equity, so the scale is lopsided toward debt. But each mortgage payment adds weight to the equity side, slowly tipping the scale over time.

Home-equity loans, also called second mortgages, are one way you can borrow against the equity you’ve built in your home and turn it into cash. Because home-equity loans often have lower interest rates, they’re considered a smart alternative to using credit cards or personal loans to fund large purchases, home renovations or emergency expenses.To be clear: home-equity loans are secured loans—and your home is the collateral. If you take out a home-equity loan and fail to make your payments, your lender could foreclose on the home.

How a home-equity loan works

With a home-equity loan, you borrow a portion of your home equity and get that money in cash after closing. Lenders typically require you to maintain at least 10% to 20% equity, meaning you can borrow up to 80% to 90% of your current home value—minus any balance you have on your existing mortgage loan.

Here’s an example: Say your home is worth $500,000, you have a $250,000 balance on your current mortgage, and your lender allows up to a 90% loan-to-value ratio. You would use this formula to calculate how much you could potentially borrow:

• $500,000 [appraised home value] x 0.90 [maximum borrowable percentage] = $450,000
• $450,000 – $250,000 [current mortgage balance] = $200,000 [amount you can borrow with a new home-equity loan] 

But, how much you technically can borrow isn’t always the same amount your lender will approve. “It’s very, very much dependent upon your borrowing profile, as well as how much equity you have in the home relative to any mortgage or additional financing you might already have,” says Robert Heck, vice president of mortgage at Morty, an online mortgage broker.

Once you’re approved for and close on your home-equity loan, you’ll get a lump sum of money that you can spend however you want. Then, you’re responsible for monthly payments of principal and interest—in addition to your primary mortgage payments. Rates on home-equity loans are typically fixed, so your rate and payment should stay consistent for your entire loan term—usually between five and 30 years. Average rates on 30-year home-equity loans in May 2024 were in the 8% range.

How to qualify for a home-equity loan

To qualify for a home-equity loan—and get the best interest rate—you usually need to have a good to excellent credit score (that’s 670 or higher) and a low debt-to-income ratio.

Your debt-to-income ratio is calculated by tallying up all of your monthly debt payments, including mortgages and any other personal debts, and dividing that by your monthly income. For example, monthly debt payments of $1,200 and a monthly income of $5,000 would equal a debt-to-income ratio of 24% (1,200 divided by 5,000). The highest ratio most lenders will accept for home-equity loan borrowers is 43%.

Your lender will also require an appraisal before you can get a home-equity loan, as this helps them determine the current market value of your property—and, thus, how much equity you have to borrow against.

If you want an estimate of how much your house is worth before applying for a home-equity loan, use free online tools from real estate marketplaces such as Zillow or Redfin, or check if your primary mortgage lender can help. “Some lenders actually have these systems available to consumers early on in the process,” Heck says. “And they may not charge for it.”

Pros and cons of home-equity loans

Compared to credit cards and personal loans, home equity loans have much lower rates (think versus single-digits versus double-digits), so they’re a handy tool if you need to pay for home renovations, unexpected expenses or any other financial need that might crop up. Their rates are also fixed, so you won’t have to deal with changing rates or payments.

Home equity loans can also qualify you for a mortgage-interest deduction (as long as you use the funds to improve your house), and they let you spread your costs out over a long period of time—typically 10 to 30 years.

On the downside, home equity loans put your home at risk. Because they use your house as collateral, your lender can foreclose on the property if you don’t make your payments.

They also add an extra monthly payment to your household, which could cause financial difficulty, and they reduce your eventual profits when it comes time to sell. Finally, most lenders require you to have a large amount of equity to qualify (usually at least 20%).

Alternatives to home-equity loans

Home-equity loans aren’t the only option if you want to turn your home equity into spendable cash. Home equity lines of credit, or Helocs, are another popular choice. Like home-equity loans, Helocs are secured by your home, but the way they function—and how you’ll pay—is a little different.

Whereas a home-equity loan gives you a lump sum of money, a Heloc acts more like a credit card. You have access to cash for a preset amount of time, known as the draw period—usually 10 years, and you’ll make interest-only payments during that time. When the draw period is up (or earlier, if you want), you start repaying what you borrowed, plus interest.

Home equity investments are another tool for tapping your home equity. These allow you to sell a portion of your home’s equity in exchange for a lump sum. Unlike home-equity loans, though, you won’t have a monthly payment. Instead, you’ll pay the investor back when you sell the house or refinance your loan.

The last way you can access your home equity is through a cash-out refinance. This method requires taking out a new loan that’s larger than your existing mortgage balance so that you can pay off the original debt and pocket some cash. In today’s market, though, these aren’t a great option for most homeowners, as the vast majority have mortgage rates much lower than current rates (which would mean trading a low rate for a higher one).

Here’s a look at how all four of these home equity options compare:

Sometimes with a cash-out refinance, your new mortgage may have a lower interest rate, too, which may lower your monthly payment. This isn’t typically the case with cash-out refinances these days, as many homeowners are locked into the ultralow mortgage rates of the pandemic days. In fact, refinances in general have fallen sharply since mortgage rates started to rise in 2022.

The locked-in rate effect is likely why home-equity loans and Helocs have grown incredibly popular. According to TransUnion, 251,000-plus Helocs were originated in the second quarter of 2023—21% more than two years earlier. Home-equity loan originations jumped over 50% to almost 240,000 in the same period.

How to use a home-equity loan

There is no limit to what you can use a home-equity loan for, but the majority of home equity borrowers—two-thirds in 2022—use the funds to pay for home renovations or remodeling projects.

While this can be a smart way to improve your home’s value, that’s not always the case. Data from Remodeling Magazine shows that typical homeowners recoup only about 66% of the cost of a bathroom remodel. Installing an upgraded garage door or stone veneer siding, though? Those recoup your costs and then some.

Another common use for a home-equity loan is to consolidate debt. Since home-equity loans typically have lower interest rates than credit cards and personal loans, homeowners can use the cash to knock out their card and loan balances and repay the debt at a more manageable rate.

“Those are really great uses,” says Eric Alexander, a financial advisor at Benchmark Income Group in Dallas. “Where I don’t really recommend either the home-equity loan or home equity line of credit is what I would call the ‘fliers,’” or speculative investments. If you spend borrowed funds on a hot stock tip that doesn’t pan out, for example, “now you’ve lost the investment and you’ve got to go repay the loan,” he says.

Shopping for the best home equity rates

When you apply for a home-equity loan, the lender assigns an interest rate to your loan after evaluating your financial profile.

“Typically speaking,” Heck says, rates on Helocs and home-equity loans are slightly higher than primary mortgage rates because the new lender is taking on more risk. (If you were to default on your debt, the home-equity lender would only get second dibs on the proceeds from your house—after your primary mortgage lender.)

Still, he emphasizes the importance of casting a wide net. “I definitely think that there’s a lot of opportunity to shop, to get lower interest rates that are going to actually be closer to what you would find on a primary mortgage from some providers,” he says.

Aim to explore loan options and get quotes from at least four to five lenders, Heck says, including a credit union, a traditional bank, your existing mortgage lender and an online lender. “Get a sense for the range of offerings across all these different types of lenders, because at the end of the day, they all have different specialties,” Heck says.

If the majority of your financial accounts are under one bank’s roof, Alexander recommends looking at that firm’s loan options first. “They’re an interested third party hoping to expand the relationship,” he says. “They’re very motivated to help you have a good experience.” That said, your current bank may not always offer the best rate.

When comparing options, find out what fees apply and the timeline for getting the cash. Be sure to ask any lender about how the home-equity loan is structured, too, Alexander says. In some cases, you may be able to switch from a variable rate to a fixed rate, or vice versa, during the repayment period.

Got a money question? Let Buy Side find the answer. Email [email protected].

Include your full name and location, and we may publish your response.