What Is a Home Equity Loan?

Definition

A home equity loan is lump-sum loan secured by the portion of your home you’ve already paid off on a mortgage loan.

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Definition and Examples of Home Equity Loans

A home equity loan is a lump-sum loan secured by the portion of your home that you’ve already paid off, or your home equity. These loans usually have equal monthly payments and may have varying durations and interest rates. This financing option often comes with attractive terms because it is considered a lower risk for banks than an unsecured personal loan.

Home equity loans are particularly popular when home values have risen, since they allow you to borrow against a higher value for your home than your initial mortgage balance, which often improves your loan-to-value (LTV) ratio. Many lenders prefer that your LTV ratio is 85% or less before you can qualify for a home equity loan, and many will only consider lending up to 80% of your current home equity.

  • Acronym: HEL
  • Alternate name: second mortgage

For example, let’s say you’ve purchased a home with a mortgage loan of $200,000 after you paid your down payment of 20%, for a total home value of $250,000. After 10 years of the 30-year loan, you realize you want to do some renovation work and need $50,000 to do so. If your loan balance is at $150,000, for example, but your home has appreciated in value to $325,000 according to an appraiser, there is a reasonable possibility (credit and other considerations not included) that you’d be approved for a $50,000 loan secured by your home. That is determined by your LTV ratio—in this case, at 46%, it’s under the required 80%—and the amount you’ve requested is less than 80% of your equity (it’s actually 29%).

How Home Equity Loans Work

The concept behind a home equity loan is fairly simple. At any given time during the life of your mortgage loan, you can calculate your loan-to-value ratio, meaning how much you still have to pay on the mortgage relative to the value of the home if it was sold today. You can do this by dividing your current loan balance by the current appraised value of your home. This ratio effectively marks how much of the house you’ve paid off. A 60% LTV would mean that 40% of the value of the home is considered fully “yours.”

Home equity loans are secured by the portion of your home’s value that you have paid off, or if you’ve paid cash or completed your mortgage, the entire value of the home. You take out a loan as a lump sum and pay it back in a set amount of monthly installments at a fixed interest rate. Some home equity loans include a penalty if you pay off your loan earlier than expected, or if you refinance.

Your home’s equity is only affected if you were to stop paying back the monthly installments on your home equity loan. At this point, your lender has the standing to foreclose on your home, using the proceeds from your home’s sale to pay off the remainder of your debts related to the home equity loan and, potentially through your other lender, your mortgage loan.

Note

Some home equity loans require a balloon payment at the end of the loan. As its name implies, it’s often much larger than your usual monthly payment. These are common with interest-only loans where your monthly payments do not pay down any of the principal. Be sure you understand your loan terms before you sign on the dotted line.

Do I Need a Home Equity Loan?

Home equity loans are often considered a smart choice should you need to access a large sum of cash quickly, but taking one can put your home at risk if you were to default. If you use this money to pay for home improvements, you may come out ahead, since many improvements add value to the home over time.

If you plan to use a home equity loan to pay off other debts or buy a car, it’s advisable to consider all your options before opting for a loan that could put your primary residence at risk.

Note

Occasionally, predatory lenders may be willing to extend a higher-interest home equity loan even if they believe you won’t be able to make the payments, or with too-good-to-be-true advertising that contains hidden fine print. Make sure you fully understand the terms of any home equity lending product before proceeding.

Alternatives to Home Equity Loans

A popular alternative that many people consider instead of a home equity loan is a home equity line of credit, or HELOC. Instead of a lump sum, this financial product gives you a credit limit as well as an interest rate, but doesn’t charge you until you borrow against that line of credit. If the line of credit is revolving, that means that as soon as you’ve paid back that money, you can borrow again up to your limit with the same payback terms.

While a home equity loan works well for a predictable, one-time expense, HELOCs can provide flexibility if you need to smooth out cash flow occasionally, or if you have unpredictable and variable expenses coming up that would necessitate some borrowed funds.

If you don’t wish to borrow against your home’s equity or haven’t yet generated enough equity to qualify for a home equity loan, your main alternative is an unsecured personal loan. These loans can come with attractive terms but are usually more expensive than secured loans.

If you have assets elsewhere, such as retirement accounts like a 401(k), you can look into your account terms to find out if a temporary loan to yourself from those funds—provided you pay it back on the correct schedule—is an option.

How To Get a Home Equity Loan

Many banks, credit unions, and other online lenders will consider a home equity loan application and offer this product. In general, the process will require you to submit documentation about your identity and your home ownership, as well as how much of a loan you want and your loan-to-value ratio. In some cases where the value has changed substantially since your home was last professionally appraised, a home appraisal may be needed to establish your most current LTV ratio.

Key Takeaways

  • A home equity loan is a loan secured by the lender’s ability to foreclose on your home, if necessary, in the case of a default.
  • Home equity loans become an option around the 85% loan-to-value ratio or less, and a lender will typically only loan up to 80% of your current home equity.
  • Home equity loans may have attractive terms given the fact that they are secured, but the consequence of potentially losing your home in the event of default should be factored into any consideration of this loan option.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Bank of America. “​​How To Calculate Home Equity and Loan-to-Value (LTV).”

  2. Federal Trade Commission. “Home Equity Loans and Home Equity Lines of Credit.”

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