What Is a Home Equity Loan? How It Works vs. a Home Equity Line of Credit

What is a home equity loan? If you own a home, you can borrow money based on its value to pay other expenses such as home improvements or college tuition. You receive a lump sum upfront, then repay it in monthly installments—plus interest—over a period of time lasting typically from five to 15 years.

Home equity loans are a popular option for homeowners because their interest rates are much lower than those for other common forms of borrowing, such as personal loans or credit cards, says Tendayi Kapfidze, chief economist at Lending Tree. And since home equity rises alongside real estate values, they’re a boon to many homeowners.

“People have been gaining home equity at an extremely fast rate,” says Ryan Kelley, CEO at TheHomeLoanExpert.com. As a result, many homeowners are turning to home equity loans to pay for a variety of things.

“We’ve seen, in the last two years, an increasing demand for home equity loans,” says Jon Giles, head of home equity lending at TD Bank.

Here’s how to decide if a home equity loan is right for you.

What is a home equity loan? How to use these funds—and why

When you get a home equity loan, you can spend that money anyway you choose. However, there are some primary ways people use their funds.

According to a recent Lending Tree study, 43% of home equity loan applicants said they planned to spend the money on home improvements.

Meanwhile, 38% of applicants said they’d use the cash to consolidate debt. That’s often a smart use, “particularly if you’re moving higher-interest debt to lower-interest debt so that you can pay off your debt more quickly,” Giles says.

Using home equity loans for education is also common, given the skyrocketing costs of college education. Plus, families with higher incomes may not qualify for grants or government-backed student loans, but they can qualify for home equity loans.

Additionally, some borrowers put the money toward a down payment on a vacation home or investment property, while others use the funds to buy a car or pay for emergency expenses.

Unfortunately, some people squander the money, obtaining a home equity loan to fund their discretionary spending. Not a great idea!

“Tapping your home equity to take a vacation, buy a yacht, or get plastic surgery would definitely be a misuse of the funds,” says Greg McBride, senior vice president and chief financial analyst at Bankrate.com.

Home equity loan vs. home equity line of credit: What’s the difference?

Many people confuse a home equity loan with a home equity line of credit, or HELOC. Essentially, a HELOC functions more like a credit card, where you’re allowed to borrow up to a certain amount of cash and then pay it off or reborrow as needed over the term of the loan (usually five to 20 years). In fact, your lender will issue you a small plastic card that looks just like a credit card, to allow you to access your money easily.

HELOCs generally have a variable interest rate, whereas home equity loans typically have a fixed interest rate. Because the interest rate is fixed on a home equity loan, you know exactly what your monthly payments will be. Meanwhile, monthly payments on a HELOC can go up or down depending on economic factors, warns Dan Green, founder at Growella.com, a mortgage education website for millennials.

Some HELOC lenders offer a low introductory rate, which lasts for a matter of months. But after that, the interest rate can fluctuate—so if you prefer steady payments, a home equity loan is a better choice for you.

How to qualify for a home equity loan

Naturally, in order to tap your home’s equity, you need to have a sufficient amount of equity built up. Most mortgage lenders will allow you to borrow up to 80% of your home’s equity when you obtain a home equity loan, says Kapfidze.

So, say your home is worth $250,000 and your mortgage balance is $200,000. In this case, you’d have $50,000 in home equity, which means you’d be able to borrow up to $40,000. (Note: Some lenders let you borrow up to 90% of your home’s equity, Kapfidze says.)

But, in order to qualify for a home equity loan, you also need reasonably strong credit.

“For most mortgage lenders, you need a credit score in the upper 600s or higher to qualify,” says Giles, adding that a credit score in the mid-700s and higher will help you qualify for the best interest rates.

And, as with a regular home mortgage, you’ll need to have an adequate debt-to-income ratio—a simple equation of your monthly debt payments divided by your monthly income—in order to qualify for a home equity loan. Generally, your DTI ratio cannot exceed 43% of your gross monthly income.

Should I get a home equity loan?

Home equity loans offer some attractive features. Most notably, “a home equity loan is a great option if you want to know exactly how much money you wish to borrow on Day 1, and you want a fixed interest rate,” Giles says.

Moreover, “having a fixed interest rate can be a big benefit when you’re in an economic environment where rates are rising like they are today,” Kapfidze points out.

Also, home equity loans can offer a nice tax break. Under the new Tax Cuts and Jobs Act, you can deduct the interest paid on up to certain amounts ($750,000 for a married couple or $375,000 for an individual), so long as you use the loan to buy or improve your first or second residence, Kapfidze says. (Read: You won’t qualify for a tax deduction if you spend the money in a different way.)

Making timely payments on a home equity loan will also improve your credit score, McBride adds.

Nonetheless, “make sure you understand how a home equity loan is going to affect your overall financial picture, and figure out a plan for how you’re going to pay back the money before you get one,” Kapfidze advises.

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