How Does a Home Equity Loan Work?

By Bill Lyons | Updated on February 2, 2024

One of the most popular ways to access your home equity is to use a home equity loan (HELOAN). Home equity loans are structured as second mortgages, but they can be especially beneficial for homeowners looking to finance large expenses. Since the loan is secured by the home itself, HELOANs often come with lower interest rates than unsecured personal loans or credit cards.

However, homeowners must be diligent with repayments since the home is the collateral. In addition, like all loans, there are benefits and drawbacks to HELOANs. So, how does a home equity loan work? Keep reading to learn more about home equity loans, how they work, and if these mortgages are right for you.

What Is a Home Equity Loan?

A home equity loan is a type of second mortgage that allows a homeowner to borrow against the equity they have built up in their home by paying their monthly mortgage bill. Equity is the difference between the current value of the property and the amount owed on the mortgage. The less you owe on your mortgage, the more equity you have built up in your home.

For instance, if your home is worth $600,000 and you owe $200,000 on your mortgage, then you have $400,000 in equity.

To get a home equity loan, lenders typically require you to have at least 15-20% equity in your home. The actual amount you can borrow will also depend on factors like your credit score, income, and overall financial health.

The borrowed funds from a home equity loan can be used for various purposes, such as home renovations, medical bills, educational expenses, or debt consolidation for higher interest debts.

When taking out a home equity loan, you should keep in mind that your home is collateral. If you fail to make payments, the lender will eventually have the right to take your home through the foreclosure process. Since you’ll be required to pay two mortgages (your original mortgage and the new second mortgage), you should always weigh the benefits of a home equity loan against the potential risks.

How Does a Home Equity Loan Work?

Over time, as homeowners consistently make mortgage payments, they accumulate equity in their property. A home equity loan allows homeowners to tap into their accumulated wealth by borrowing a lump sum of money using the equity built up in their home as collateral. The loan amount is typically determined by several factors, including the amount of equity available, the borrower’s credit history, and other financial considerations.

A home equity loan typically comes with a loan term that’s similar to a typical mortgage. HELOANs often come with 15, 20, 25, or 30-year terms. Griffin Funding offers standard terms, in addition to a 40-year fixed-rate HELOAN and interest-only HELOAN options.

HELOANs also have a fixed interest rate to ensure that monthly payments remain consistent throughout the life of the loan. Borrowers receive the loan amount in one lump sum and repay it in fixed monthly installments, similar to their first mortgage.

Understanding interest rate and home equity is also crucial. Ultimately, home equity loan rates are typically much lower than other borrowing options like personal loans or credit cards. This makes home equity loans a great option for those who have various sources of debt that they’d like to consolidate at a lower rate.

Home equity loan vs. home equity line of credit

When homeowners want to tap into their equity, there are two popular options: Home equity loans (HELOANs) and home equity lines of credit (HELOCs). Both options rely on home equity as collateral, but they function differently.

As discussed, a home equity loan is a second mortgage that allows homeowners to borrow a lump sum of money upfront, which is repaid over a predetermined period with a fixed interest rate. This structure ensures consistent monthly payments, making it easy for borrowers to budget. These loans are typically the preferred option for borrowers with one large immediate expense like a home renovation or debt consolidation.

On the other hand, a home equity line of credit works like a credit card or any other line of credit. Instead of receiving a lump sum, homeowners are given a line of credit up to a certain amount, which they can draw from as needed. HELOCs typically come with variable interest rates, meaning monthly payments fluctuate. However, the flexibility of HELOCs is ideal for ongoing expenses or when the exact amount needed is unknown.

Choosing between a HELOAN and a HELOC often boils down to individual needs and financial preferences. You should carefully evaluate your financial situation, predictability of expenses, and comfort level with varying interest rates.

Home equity loan vs. cash-out refinance

Another option for accessing your home’s equity is a cash-out refinance. Unlike HELOANs and HELOCs, cash-out refinances are not second mortgages. Instead, they replace your existing mortgage with a new one. The new loan is for a larger amount than you currently owe, so the difference between the new, larger mortgage and the amount you previously owed is paid to you in cash.

Since a cash-out refinance replaces your original mortgage, you can expect different loan terms, potentially a different interest rate, and a reset loan duration. This option can be advantageous if current market rates are lower than your existing mortgage rate or if you want to change your mortgage’s term.

When deciding between a cash-out refinance and a home equity loan, you should consider your current mortgage rate, how long you intend to stay in the home, and your specific financial goals. A HELOAN might be more suitable for those with favorable mortgage rates they don’t want to lose, while a cash-out refinance may be best for those who want to capitalize on low interest rates or consolidate high interest debt.

In addition, it’s important to recognize the costs associated with each option. Cash-out refinances come with similar costs to your initial mortgage, such as appraisal, origination, and closing fees. On the other hand, HELOANs may have lower closing costs. Over the long term, the costs associated with refinancing might be justified by the potential savings from a lower interest rate and lower monthly payments. Still, it’s crucial to crunch the numbers and ensure the benefits outweigh the costs.

Another consideration is the loan term. When you get a cash-out refinance from Griffin Funding, you can get a customized loan term that’s tailored to how far along you are in your current mortgage. For example, if you’re four years in to a 30-year mortgage, you can get a 26-year cash-out refinance loan (or opt for a shorter loan term if you prefer). Once you’ve taken out this loan, you can take the money you saved by consolidating debt with a cash-out refinance and put it towards the principal amount on your mortgage so you can pay off your home quicker and save on interest over the life of the loan.

A home equity loan, on the other hand, has more fixed loan terms that are similar to what you would find with a traditional mortgage. Typical HELOAN terms are 15, 20, 25, or 30-years, however Griffin Funding offers HELOAN terms as long as 40-years. With a short home equity loan term, you’ll have to deal with higher payments but will pay less in interest over the life of the loan. A longer loan term will result in lower monthly payments, but more interest paid over the life of the loan.

Home Equity Loan Qualification Requirements

Home equity loans offer homeowners the opportunity to tap into the equity they’ve built in their home, ultimately to be able to actually use their investment. These loans offer financial flexibility, whether for home improvements, consolidating debt, or funding life events. However, like all loan programs, borrowers must meet specific requirements to secure these loans.

While lending requirements vary by lender, here are a few general guidelines:

• Sufficient home equity: Not all equity is tappable equity. Most lenders require you to retain at least 10-20% equity in the home after the loan, which provides a cushion in case home values decrease. In other words, this means that you can’t borrow the full amount of equity built up. Instead, you can only borrow up to 80-90% of it.
• Credit score: Your creditworthiness plays a large role in determining your loan terms and interest rate. A good credit score, typically around 680 or above, demonstrates a history of responsible credit management and timely payments, giving lenders more confidence in your ability to repay the loan. Griffin Funding will accept a credit score as low as 660, but keep in mind that a higher credit score will lead to better rates and terms.
• Debt-to-income (DTI) ratio: The DTI ratio is a metric lenders use to evaluate whether you can afford a new loan. It measures your monthly debt payments against your gross monthly income. Lenders typically look for a DTI below 43%, as it indicates a better balance between income and debt. However, Griffin Funding will accept a DTI of up to 50%.
• Loan-to-value (LTV) ratio: LTV is related to the equity you have in your home and is calculated by dividing the amount you owe on your mortgage by the property’s appraised value. For example, if you owe $150,000 and your home is appraised at $200,000, the LTV is 75%. Lenders have a preferred LTV threshold and typically prefer an LTV of 80% or lower.
• Stable employment and income: Consistent income ensures you can meet the monthly repayment obligations of a home equity loan. Lenders will typically request pay stubs, W-2s, and tax returns to verify your employment status and income levels. Those who are self-employed or have variable income might face more scrutiny and need to provide additional documentation. However, they can also apply for a no doc home equity loan that allows them to qualify using alternative documentation. For instance, they might use a bank statement home equity loan that allows them to qualify using 12 or 24 months’ worth of bank statements rather than pay stubs or W-2s.
• Property type and condition: The type of property and its condition can also influence a lender’s decision. A primary residence might have different equity requirements compared to a rental property or vacation home, depending on the lender. Additionally, lenders want to ensure their investment is sound. Homes that require significant repairs or are in areas prone to natural disasters might have stricter loan terms or be ineligible for some HELOANs.

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Pros and Cons of Home Equity Loans

Home equity loans can be a solution to many financial needs, from significant expenses like education to debt consolidation. However, like all financial tools, HELOANs come with their own set of advantages and disadvantages.

Benefits of home equity loans

The most significant benefit of a home equity loan is that it allows you to leverage the equity you’ve built in your home by paying down your principal balance. Other benefits of these loans include the following:

• Fixed interest rates: One of the primary benefits of home equity loans is that most of them come with fixed interest rates. Unlike variable interest rates that are influenced by market fluctuations and can lead to unpredictable monthly payments, fixed interest rates remain unchanged over the loan’s term. This predictability can offer stability and transparency. Knowing the exact amount you’ll pay each month can improve budgeting and financial planning, removing the pitfalls of potential rate hikes.
• Lump sum payment: Upon loan approval, borrowers will receive a one-time lump sum payment, allowing them to cover significant expenses upfront. This can be especially beneficial for projects with a large initial cost, like home improvements or educational expenses. For instance, homeowners looking to renovate parts of their houses can immediately pay contractors, purchase the necessary materials, and cover other upfront fees without waiting. Similarly, those who want to fund a child’s college education can cover tuition or accommodation costs immediately, eliminating the need to draw on credit.
• Potential tax benefits: Depending on how the borrowed amount is used, home equity loans might come with potential tax benefits. The interest paid on the loan could be tax-deductible for homeowners who utilize the funds specifically for home renovations or improvements. This provision can offer significant annual savings, reducing the cost of borrowing. However, tax laws and benefits vary, with specific criteria you must meet. Consulting with a tax professional can help you determine if the interest paid on your HELOAN qualifies for these deductions.
• Lower interest rates than other loans: Compared to personal loans, credit cards, or business loans, home equity loans offer significantly lower interest rates since they’re secured against your home. Over the life of the loan, this rate difference can translate into substantial savings, making home equity loans a cost-effective option for many borrowers.
• Flexible use of funds: While your primary mortgage can only be used to purchase a home, a second mortgage can be used for a wide range of purposes, from medical expenses to debt consolidation. This flexibility allows the homeowner to tailor the borrowed funds to their unique needs and circumstances, offering a financial tool that adapts to various situations.

Downsides of home equity loans

Like all mortgages, HELOANs come with their own set of disadvantages. Ultimately, these loans aren’t the best option for everyone looking to tap into their home equity. Weighing the pros and cons together can ensure you make the right decision. The potential disadvantages of home equity loans include the following:

• Increased risk of foreclosure: Since home equity loans use your home as collateral, failing to repay the loan could result in foreclosure, making it a riskier option than unsecured loans.
• Closing costs and fees: Acquiring a home equity loan comes with various fees, including application fees, appraisal fees, and closing costs. These costs can add up and increase the overall cost of the loan.
• Longer debt cycle: By tapping into home equity, you could be extending the amount of time it takes to fully own your home, especially if you had been close to paying off your original mortgage.
• Market fluctuations: If property values in your area decline, you might end up owing more on your home than it’s worth. This scenario, called an “underwater mortgage,” can complicate matters if you decide to sell the home or refinance the loan.
• May reduce future equity: Since you’re borrowing against your home’s equity, a home equity loan could potentially reduce the amount of profit you’d make from selling your home in the future.

Take Advantage of Our Competitive Home Equity Loan Rates

A home equity loan allows you to leverage the value you’ve built up in your home, providing a method to fund everything from home renovations and educational expenses to significant life costs. These loans come at relatively lower interest rates compared to other lending options, allowing you to potentially save over the life of the loan.

Secured against the property, HELOANs provide lenders and borrowers with added security, leading to favorable terms and substantial savings over time. However, as with any financial decision, homeowners should assess their individual circumstances, understand their loan terms, and consider the long-term implications before committing to a HELOAN.

Tap into your home’s equity with Griffin Funding. We’re committed to offering some of the most competitive home equity loan rates, providing financial solutions based on your unique needs to ensure every loan we provide aligns with your goals and aspirations. Apply for a mortgage online today, or contact us to learn about the different options we provide for tapping into your home’s value.

Bill Lyons

Bill Lyons is the Founder, CEO & President of Griffin Funding. Founded in 2013, Griffin Funding is a national boutique mortgage lender focusing on delivering 5-star service to its clients. Mr. Lyons has 22 years of experience in the mortgage business. Lyons is seen as an industry leader and expert in real estate finance. Lyons has been featured in Forbes, Inc., Wall Street Journal, HousingWire, and more. As a member of the Mortgage Bankers Association, Lyons is able to keep up with important changes in the industry to deliver the most value to Griffin's clients. Under Lyons' leadership, Griffin Funding has made the Inc. 5000 fastest-growing companies list five times in its 10 years in business.