A home equity loan is one of the ways you may borrow money using the equity you’ve built in your home as collateral. Here’s how it works step by step:

 

Understand the term “home equity”

Your home equity is the difference between what your home is worth and what you still owe on your mortgage.

Example:

• Home value: $300,000
• Mortgage balance: $200,000
• Equity: $100,000

Lenders usually let you borrow up to 80–85% of your home’s value (minus what you owe on your mortgage).  Thus $300,000 x .80 (80%) = $240,000 is the total loan for this example.  Finishing the math, the total debt would be $240,000, less the current mortgage of $200,000 equals $40,000 in this 80% loan to value example.   

In this case, you might borrow up to $40,000–$55,000.

 

It’s a lump-sum loan

Unlike a home equity line of credit (HELOC), which works like a credit card to pay for items or services using home equity debt as you need it, up to a limit, a home equity loan gives you one lump sum up front.

• You repay it with fixed monthly payments (principal + interest) over a set period — usually 5 to 30 years. (A HELOC payment varies based upon the outstanding loan amount)
• The interest rate is typically fixed, so your payments stay the same each month. (A HELOC is often a variable rate.) 

 

It’s secured by your home

Your home acts as collateral, meaning:

• If you don’t make payments, the lender can foreclose on your home.
• Because of this security, interest rates are often lower than for credit cards or personal loans.

Common uses

People often use home equity loans for:

• Home improvements (especially projects that raise property value)
• Debt consolidation
• Education expenses
• Major purchases or emergencies

But using it for non-essential spending can be risky since your home is on the line.

 

Pros and cons

Pros: 

• Fixed interest rate and payment
• Potential tax deduction if used for home improvements
• Lower rate than unsecured loans
• Large lump sum for big expenses

 

Cons:

• Risk of losing your home if you default
• Possible closing costs and fees, which could potentially add 2-5% of loan
• Adds a second monthly payment if you still have a mortgage
• The market value of the home could drop, reducing equity and possibly owing more than the house could currently sell for. 

 

Tip:

Before agreeing to a home equity loan, compare offers from multiple lenders, compare the rates, the number of payments, the fees and the money you expect to get. Then check your credit score and calculate how the new loan affects your debt-to-income ratio.

To calculate your debt-to income (DTI) ratio, follow these steps:

• Add up your monthly debt payments. This includes housing costs, loans, credit card payments, and any other regular debt obligations.
• Determine your gross monthly income. This is your total income before taxes and other deductions.
• Divide your total monthly debt payments by your gross monthly income. The formula is DTI = (total monthly debt payments / gross monthly income.
• Interpret the result. A DTI ratio of 36% or less is generally considered good, while 50% or more is considered high.

This calculation helps lenders assess your ability to manage monthly payments and repay debts.

The average credit score for a mortgage typically falls within the following ranges:

• A FICO score of at least 580 is generally needed to qualify for a mortgage.
• A favorable credit score is usually in the high 600s to 700s.
• Scores above 760 are often associated with the best mortgage rates.
• Some loans may allow for scores as low as 500, but this is considered low.

These ranges can vary based on the lender and the type of mortgage.