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How does a home equity loan work?

Home equity was up $1 trillion in the fourth quarter of 2022. Want to tap into it? Here’s how a home equity loan works.

With enough home equity, you can borrow using your house as collateral.

With enough home equity, you can borrow using your house as collateral.

Constantine Johnny/Getty Images

Homeownership offers many perks, but the greatest may be the opportunity to build wealth. As you pay down your mortgage, you build equity — the dollar amount of your home that you own. Fluctuations in the housing market influence equity, too (for better or worse), and if house prices rise, your home equity can increase, and vice versa. Home equity has been way up over the past year: In fact, homeowners in the U.S. gained $1 trillion in home equity during the fourth quarter of 2022, according to a recent report from real estate data service CoreLogic.

With enough home equity, you can borrow using your house as collateral. One option is a home equity loan, where you borrow a lump sum that you repay over a set term. If you could use cash for home improvements, debt consolidation, or other expenses, here’s how to get a home equity loan in 2023. 

What is a home equity loan?

A home equity loan (aka second mortgage) lets you borrow using the equity in your home as collateral. To estimate your home equity, take your home’s current value and subtract what you owe on your mortgage. So, if your home is worth $300,000 and your mortgage balance is $100,000, your equity would be $200,000.

How does a home equity loan work? 

Once you’re approved for a home equity loan, your lender gives you the funds as an upfront lump sum. This makes home equity loans ideal for homeowners who want to borrow a specific amount for a major project or big one-time expense. To repay the loan, you make fixed monthly payments (with interest, of course) over a set term ranging from five to 30 years.

TIP: Remember that home equity loan payments are in addition to your usual mortgage payments, so budget accordingly. If you default on the loan payments, your lender can foreclose on your home.

How much equity can I borrow?

Many lenders let you borrow up to 80% of your available home equity. If you have $200,000 in equity, for example, you can borrow up to $160,000. Of course, the loan amount also depends on your financial situation: Lenders consider factors like your credit score, income, employment history, and debt-to-income (DTI) ratio when deciding whether to approve or deny your loan application.

What can I use a home equity loan for?

You can use a home equity loan for virtually anything, but some choices are better (i.e., more financially sound) than others. It’s wise to focus on things that boost your home’s value or improve your financial situation in some other way — say, home improvements or debt consolidation. Conversely, spending on unnecessary expenses like an extravagant vacation or a risky investment is ill-advised. Remember: Your home secures the loan, and your lender can foreclose if you default.

Current home equity loan rates

Home equity loans and HELOCs generally have higher rates than mortgages because they represent a larger risk to the lender. Several factors influence interest rates, including inflation, job growth, the Federal Reserve’s monetary policy decisions, and your financial situation.

According to Bankrate, the average home equity loan rates as of March 28 are:

  • 10-year fixed: 8.15%

  • 15-year fixed: 8.11%

The average home equity line of credit (HELOC) rate is lower at 7.78%. Shopping around with at least three lenders can help you find the best home equity loan rates and the best HELOC rates.

TIP: The rate you lock in for a home equity loan or HELOC could be higher or lower than the average rate, depending on your credit score and other factors.

Home equity loan vs. HELOC

Home equity loans and HELOCs let you tap into your home equity, but they work differently. A home equity loan is a lump-sum payment, so it can be a good option if you need a set amount of money for a particular project. On the other hand, a HELOC is a revolving credit line that you can draw from as needed for a certain number of years. This makes a HELOC a smart choice if you don’t have an exact budget or timeline in mind.

Home equity loan requirements in 2023

You’ll need to meet specific requirements to get a home equity loan or HELOC, much like when you got your mortgage. The requirements are generally the same whether you get a home equity loan or HELOC, but they vary by lender. Still, here’s what lenders typically look for:

1. At least 15% equity in your home

Your home serves as collateral, so your lender will expect you to have a minimum amount of equity. The more equity you have, the more you can usually borrow. Lenders also use a related metric called the loan-to-value ratio (LTV) to measure a loan’s potential risk and decide whether to approve your application. To calculate LTV, divide your current loan balance by your home’s value. Lenders consider loans with higher LTVs riskier because your stake in the house is lower.

As equity increases, LTV decreases. To illustrate, here’s what happens to equity and LTV as the loan balance drops on a $500,000 home:

Another calculation is the combined LTV (CLTV) ratio, which compares the value of your home to the combined total of loans it secures. To calculate CLTV, divide your combined loan balance by your home’s current appraised value. Most lenders require a CLTV below 85% to approve a home equity loan or HELOC.

2. A credit score above 620

You’ll likely qualify for a loan with a credit score of 680 or higher if you meet the other requirements, but some lenders prefer a score of 700 or more. If your credit score falls below 680, you might still qualify if your financial profile is strong in other areas. Lenders also like to see a strong history of paying your bills on time because it shows you’re a reliable borrower.

3. A DTI ratio below 50%

Your debt-to-income (DTI) ratio is your total monthly debt payments divided by your gross monthly income. The lower your DTI, the better (it indicates your debt is manageable). Qualifying DTI levels vary by lender: Some require your DTI to be 36% or less, while others accept DTIs as high as 43% or 50%. Also, lenders require income proof to confirm you can manage your loan payments.

Bottom line

Homeowners in the U.S. are holding near-record levels of equity. While some real estate markets are seeing price drops, housing experts don’t expect a repeat of the Great Recession. As such, now might be a good time to consider a home equity loan or HELOC as housing prices remain high. 

Editorial Disclosure: All articles are prepared by editorial staff and contributors. Opinions expressed therein are solely those of the editorial team and have not been reviewed or approved by any advertiser. The information, including rates and fees, presented in this article is accurate as of the date of the publish. Check the lender’s website for the most current information.

This article was originally published on SFGate.com and reviewed by Lauren Williamson, who serves as Financial and Home Services Editor for the Hearst E-Commerce team. Email her at lauren.williamson@hearst.com.