How Does a Home Equity Loan Work?

How does a home equity loan work? Home equity loans are mortgages similar to the one you probably used to buy your house. When you take out home equity financing, you add a new loan against your home in addition to your first mortgage. That’s why another name for home equity loans is “second mortgage.”

How Much Can You Borrow With a Home Equity Loan?

As the name implies, a home equity loan is a form of borrowing that is secured by your home equity. But what is home equity?

Home equity is the difference between your home’s market value and your current mortgage balance. Imagine that your home is worth $500,000. And your mortgage balance is $400,000. Your home equity is $100,000. ($500,000 - $400,000 = $100,000.

But don’t think you’ll be able to borrow $100,000. To protect itself, your home equity lender requires you to leave a home equity cushion when you borrow.

Easy way to calculate your CLTV

To know how much you can borrow, you need to understand “combined loan-to-value ratios,” aka CLTVs. Luckily, these are easy to calculate. 

You just divide the total amount secured by your home (your main mortgage balance and your new home equity loan, plus any other loans against the property) by your home's value.

In our example, you currently have only a main mortgage with a $400,000 balance. So you divide that balance by your home’s value:

$400,000 ÷ $500,000 = 0.8

Multiply that 0.8 by 100 to create a percentage and your LTV is 80%. It’s not a combined loan-to-value ratio yet because you’re only counting your main mortgage. It's a CLTV when there’s more than one loan secured on your home.

Some lenders insist that your CLTV can’t be higher than 80%. And, in our example, that would mean that you can’t get a home equity loan from one of those lenders until your equity has grown more. It’s already at 80%.

However, nowadays, plenty of lenders are happy with CLTVs of 90%. And 90% of your home’s value of $500,000 is $450,000. ($500,000 x 90% = $450,000.) That’s your $400,000 existing mortgage balance plus up to $50,000 for a new home equity loan.

So, providing your lender thinks you’re a creditworthy borrower who can comfortably afford the new monthly payments on your home equity loan, you can probably borrow $50,000.

Home equity at record highs

We deliberately chose a borderline example. However, many homeowners have much more equity than that. Indeed, the amount available hit record highs at the end of 2021. 

And, according to CoreLogic, on average, American homeowners each saw their home equity rise by $55,000 just over the 12 months ending in December 2021.

So there’s a good chance you have way more home equity than you realize. 

Home Equity Loan Interest Rates

How does a home equity loan work when it comes to interest rates? Most have fixed interest rates. And your payments are fixed, equal installments that last for a fixed term. And all that “fixing” means budgeting for them couldn’t be simpler. 

Like all loans, you’re likely to be offered a lower rate the more convinced your lender is that you’re a low-risk borrower.

A lender will check the following to gauge how good or bad a risk you are. Your: Credit score – Shows how responsible a borrower you’ve been, which is usually a good indicator of how responsible you’re going to be

• LTV – (See above.) The more equity you retain in your home, the lower the risk of your lender making a loss if the loan goes bad
• DTI – Your debt-to-income ratio looks at your monthly housing costs, debt payments, and other inescapable obligations as a percentage of your gross income. That shows how easy you might find it to keep up with your new loan’s payments
• Employment and income records – How secure are your earnings and other income sources? If you keep aimlessly switching jobs or have a wildly fluctuating income, you may encounter times when repaying your debt becomes an issue
• Assets – These aren’t always needed. But, if you have some, they reassure the lender you stand a good chance of riding out tough times

If you score exceptionally highly on all of those, you could be in line for a very low rate. But the more issues you have, the higher your rate will creep until your application could be declined altogether.

Yes, but the rates …

It’s understandable that you want us to quote actual rates. But they change every day, sometimes more than once. And it’s all-but-certain that they’ll have changed significantly by the time you read this.

What we can do is give you the range of rates that were being advertised on the day this was written, toward the end of March 2022. To repeat, they won’t still apply when you’re reading this. But they do give an idea of the range. 

A look at several national sites came up with rates for a 10-year, fixed-rate home equity loan ranging from 3.50% to about 8%. For a 15-year term, the range was 3.75% to about 8%. 

Such rates are generally higher than those for cash-out refinances, but lower than those for personal loans, credit cards, and other unsecured borrowing.

Home Equity Loan Closing Costs

According to Time magazine, closing costs on a home equity loan tend to range between 2% and 5% of the loan’s value. That’s the same proportion of the loan’s value that most mortgage closing costs represent. 

But, of course, most people borrow less with a home equity loan than a whole new first mortgage. So, in dollar terms, the amount of those costs will usually be significantly lower. That’s why so many borrowers prefer this sort of loan to a cash-out refinance: They save a bundle on closing costs. 

And they may save an even bigger bundle by comparison shopping for their home equity loan. At least one lender pays all closing costs incurred during the loan process so that you don’t have to bring any cash to your loan closing.

Bear this in mind when you’re comparing quotes from lenders. If you currently have plenty of cash, you may be better off paying high closing costs if the lender offers an uber-low interest rate in return. 

But, if your priority is getting your hands on every cent you can, you may be willing to pay a higher rate in exchange for low or zero closing costs. Sometimes, you have to sacrifice your long-term interests for necessary short-term advantages.

Home Equity Loan Terms

Most home equity loan terms range between 10 and 15 years. But it’s not hard to find loans that are longer (20 or even 30 years) or shorter (five years). 

Obviously, the longer the loan term, the lower the payment. So, if affordability is a concern, you may require a longer term. But this will push up your total interest costs because you’re borrowing a large sum over a long time. 

The shorter your loan term, the less your interest expense will be. To keep your cost as low as possible, then, look for the shortest home equity loan terms that you can afford.

Use a home equity loan calculator to model your options and discover your likely monthly payments.

How to Shop for a Home Equity Loan

As we’ve already said, it’s crucial that you comparison shop for your home equity loan. Interest rates and closing costs vary hugely between lenders. And the more quotes you compare, the better your chance of finding your best possible deal.

We can get you started with some great lenders. But, by all means, shop more widely. Talk to your existing mortgage lender and your bank or credit union. Ask friends and family for recommendations. And get as many quotes as you reasonably can.

Don’t worry about this messing up your credit score. For this type of loan, the Consumer Financial Protection Bureau says: “The impact on your credit is the same no matter how many lenders you consult, as long as the last credit check is within 45 days of the first credit check.”

How to Apply for a Home Equity Loan

Your home equity loan application process depends on the lender, your requirements, and the strength of your application. 

In general, however, you’ll need to supply proof of income. This can be:

• Most recent pay stub if you’re a wage earner with a stable job history
• Two years of tax returns  if you’re self-employed or earn commission income
• Award letters or proof of deposit for social security, disability or pension income
• Deposit records and a court order for child support

You’ll authorize the lender to check your credit, and you’ll need credit scores that meet the lender’s guidelines. In most cases, the minimum credit score for home equity loans is 620, and a 680 score gives you an excellent chance of loan approval. 

The lender also calculates your debt-to-income ratio (DTI). That’s your total monthly debt payments (mortgages, auto loans, credit card minimums, etc.) divided by your monthly gross (before-tax) income. Lenders like to see this number at 43% or lower. 

Your lender may require a home appraisal or it may just go with software-generated valuation. How to apply for a home equity loan often depends on the strength of your application. If you’re a “no-brainer” applicant with high income and credit scores, and low DTI and LTV, you may get an approval quickly with little fuss. Otherwise, you and your loan officer will have to work harder and provide more documentation to convince an underwriter that you;re a good risk. 

Can You Refinance a Home Equity Loan?

How does a home equity loan work when you want to refinance it? Because you normally can refinance one. 

People refinance home equity loans for varying reasons, including:

• The borrower needs more cash than the old home equity loan provided
• Better rates are available because the borrower’s credit score improved or because interest rates in general have fallen.
• The borrower wants more time to repay the remaining balance. Stretching it over a new term reduces the payment even if the rate stays the same. Refinancing a home equity loan involves costs, however. So you probably shouldn’t refinance without a compelling reason.

How Does a Home Equity Loan Work? Just Fine!

For nearly all homeowners, a home equity loan is a useful and trouble-free financial tool. It:

• Provides you with a lump sum that you can use for any purpose: from home improvements to investment and from debt consolidation to unexpected medical bills
• Generally has lower interest rates than other forms of borrowing except mortgages
• Typically has a fixed interest rate, protecting you from future rate hikes
• Has equal monthly payments over a set period, making it easy to budget for
• Gives you plenty of term options so you can optimize affordability and borrowing costs

Of course, these loans are second mortgages. And you should always weigh the pros and cons when you’re putting your home on the line. But now we’ve answered our initial question: “How does a home equity loan work?” Do you agree with us that they work just fine for nearly everyone?