Home Equity Lending: A Guide to Using Your Home’s Value

Your home is often your most valuable asset, but its value is “locked in.” If you need a large amount of capital for a major expense, like a home renovation, debt consolidation, or education costs, home equity lending is a common way to access those funds. This method allows you to borrow against the value you have built up in your property.

However, this also means you are using your house as security, which carries significant risk. This guide will explain exactly what a Home Equity Loan (HEL) is, how it’s calculated, and how it compares to its flexible alternative, so you can make an informed decision.

1. What Is a Home Equity Loan?

A home equity loan (HEL) is a type of loan that allows a homeowner to borrow money using their home’s equity as collateral. Equity is the portion of the home the owner truly “owns” (the market value minus the mortgage balance).

This type of equity housing loan provides the borrower with a single, lump-sum payment upfront. The loan is then repaid over a fixed term, typically 5 to 30 years, with predictable monthly payments at a fixed interest rate.

Because this home equity loan is taken out against the home’s value, separate from the primary mortgage, it is often called a “second mortgage.”

This method of borrowing from equity is well-suited for large, one-time expenses. According to the U.S. Federal Reserve, over 30% of American homeowners utilize this loan type to finance major projects such as home improvements, education expenses, or debt consolidation (Federal Reserve Board, 2007). This form of borrowing significantly increases access to capital at lower interest rates compared to traditional consumer credit.

2. How a Home Equity Loan Works

A home equity loan functions in a few clear, distinct steps, from calculating your equity to receiving your funds and repaying the loan.

2.1. Determining Your Home Equity

First, the lender must determine how much equity you have. Equity is the difference between what your home is worth and what you still owe on it.

The Formula:

A Simple Example: If your home is valued at $400,000 and you still owe $250,000 on your primary mortgage, you have $150,000 in home equity.

2.2. The Loan Process

The process for getting a homeowners equity loan is similar to getting a regular mortgage:

1. Apply: You submit an application to a lender (bank, credit union).
2. Appraisal: The lender will order an appraisal to get an official valuation of your property.
3. Approval: The lender reviews your application, home value, credit, and income.
4. Receive Funds: Once approved, you receive the full loan amount in a single, lump-sum payment.

After receiving the money, you begin repaying the loan in fixed monthly installments, which include both principal and interest, at a fixed interest rate.

2.3. Interest and Repayment

The repayment structure is one of the main features of this equity mortgage loan.

• Fixed Interest Rate: The interest rate is locked in at the beginning and will not change for the entire life of the loan. This makes it very easy to budget, as you always know exactly what your payment will be.
• Stable Payments: Your monthly payment remains the same every month for the full repayment term of the loan (e.g., 5, 15, or 30 years).

3. Home Equity Loan Requirements

Lenders (like banks and credit unions) have specific requirements to approve an equity loan. They must verify that the borrower can repay the loan and that the home has enough value to serve as collateral.

These are the most common home equity loan terms and requirements:

• Minimum home equity: Lenders typically require the homeowner to retain at least 15% to 20% of their equity. They use a “Combined Loan-to-Value” (CLTV) ratio, usually capping the total debt (primary mortgage + new loan) at 80% to 85% of the home’s value.
• Good credit score: While standards vary, most lenders look for a FICO credit score of at least 620. A higher score (700+) not only improves the chance of approval but also helps secure a lower interest rate.
• Debt-to-income (DTI) ratio: Lenders review the borrower’s DTI. This ratio compares total monthly debt payments (including the proposed new loan) to gross monthly income. Most lenders prefer a DTI of 43% or less.
• Stable income verification: The applicant must prove they have stable and verifiable income sufficient to afford the new monthly payment. This is typically verified using recent pay stubs, W-2 forms, and tax returns.
• Home appraisal: The lender will order a home appraisal. This independent valuation confirms the property’s current market value, which is necessary to finalize the loan amount based on the CLTV ratio.

4. Advantages and Disadvantages

A home equity loan can be a useful financial tool, but it is important to understand both the benefits and the significant risks involved.

4.1. Advantages

Taking a loan on equity of home offers several clear benefits compared to other types of debt.

• Lower interest rates: Because the home equity loan is secured by your home, lenders offer much lower interest rates than you would get with unsecured consumer debt like personal loans or credit cards.
• Predictable fixed payments: The interest rate is fixed for the life of the loan. This means the monthly payment never changes, which makes budgeting simple and predictable.
• Access to a large sum: Homeowners can often borrow a significant amount of money (typically up to 80-85% of their equity), which is ideal for large, one-time projects.
• Potential tax benefits: In the U.S., the interest paid on a home equity loan may be tax deductible. However, the rules changed with the Tax Cuts and Jobs Act of 2017 (which superseded rules from the Tax Reform Act of 1986). Interest is now only tax deductible if the funds are used to “buy, build, or substantially improve” the home that secures the loan (according to IRS rules) (Internal Revenue Service [IRS], 2024; Congress.gov, n.d.).

4.2. Disadvantages

The risks of an equity loan are significant and must be taken seriously.

• Risk of foreclosure: This is the biggest drawback. Because the loan is a second mortgage secured by your house, you could lose your home if you fail to make the monthly payments. 
• High upfront costs: These loans often come with closing costs, just like a primary mortgage. These can include appraisal fees, origination fees, and title fees, which can add up.
• Reduced net worth: You are borrowing against the value you have built in your home. This process reduces your home equity and increases your total debt.
• No flexibility: You receive the money in one lump sum. Unlike a HELOC (Home Equity Line of Credit), you cannot draw more money as you pay the loan down. It is a one-time transaction.

5. Home Equity Loans vs. HELOCs

One of the most important decisions in home equity lending is choosing between a Home Equity Loan (HEL) and one of the Home Equity Lines of Credit (HELOC). Although both use your home’s equity, they function in completely different ways. A HEL is a lump-sum loan, while a HELOC is a flexible credit line.

Here is a simple comparison:

Feature	Home Equity Loan (HEL)	Home Equity Lines of Credit (HELOC)
How You Get Funds	A single, lump-sum payment upfront.	A revolving credit line you can draw from as needed (like a credit card).
Interest Rate	Fixed – The rate does not change for the life of the loan.	Variable – The rate can change with the market.
Repayment	Fixed monthly payments.	Variable payments, often with an “interest-only” draw period, followed by a repayment period.
Best For	Large, one-time, fixed expenses (e.g., a major renovation or debt consolidation).	Ongoing or flexible expenses (e.g., medical bills, phased projects).
Main Risk	The primary risk is foreclosure if you fail to make the fixed payments.	Payments can rise significantly if market interest rates go up (also carries foreclosure risk).

6. Special Considerations

Before taking out a home equity loan, it is crucial to understand the specific terms, costs, and legal rights associated with the loan.

6.1. The Right to Cancel (Right of Rescission)

Under U.S. Federal Law (the Truth in Lending Act), borrowers have a “Right of Rescission.”

This right gives a homeowner three business days to cancel the loan agreement after signing, for any reason, without penalty. This “cooling-off” period applies to a home equity loan and other loans that use a primary home as collateral. To cancel the loan, the borrower must send a written notice to the lender; a phone call is not sufficient.

6.2. Closing Costs

A home equity loan is a type of mortgage, and it comes with closing costs, which will be detailed in a good faith estimate from the lender. These fees must be factored into the total cost of the loan.

Common costs may include:

• An appraisal fee (to determine the home’s value)
• A title search fee
• An origination fee (for processing the loan)
• Other administrative or legal fees

These closing costs typically range from 2% to 5% of the total loan amount.

6.3. Responsible Borrowing

Using a home as an ATM is a significant financial risk. Financial experts generally advise using a loan on equity for long-term value creation, not short-term consumption.

• Good uses: Home improvements (which can increase the home’s value), debt consolidation (if it lowers the overall interest rate), or major educational expenses.
• Poor uses: Vacations, luxury goods, or daily living expenses.

It is also wise to avoid borrowing 100% of the available equity. Lenders generally require homeowners to retain at least a 15-20% equity stake as a safety buffer.

7. Alternatives to Home Equity Loans

A home equity loan is not the only way to access cash. Before committing, it is important to understand the other common options, as they may be a better fit for your financial situation.

• Cash-Out Refinance: This option replaces your current, primary mortgage with a new, larger one. You receive the difference between the new, larger loan amount and what you owed on your old mortgage in cash.
  • Key Difference: This is not a second loan. It is a completely new primary mortgage, usually with a new interest rate and new terms.
• Personal Loan: An unsecured loan, meaning your home is not used as collateral.
  • Key Difference: Because the loan is not secured, it is less risky for the borrower (you cannot lose your home if you default). However, this higher risk for the lender means interest rates are significantly higher than a home equity loan.
• Reverse Mortgage: A special type of loan available only to homeowners aged 62 or older who have significant equity.
  • Key Difference: Instead of you paying the bank, the bank pays you. You can receive your equity as a lump sum, monthly payments, or a line of credit. The loan does not have to be repaid until the homeowner sells the home, moves out, or passes away.

8. Frequently asked questions about Home Equity Lending

9. The Bottom Line

A home equity loan is a major decision in home equity lending. It can be a reasonable financial choice if you are a homeowner with equity and need a loan against equity with a low, fixed interest rate and predictable payments.

However, it is crucial to remember that the loan is secured by your home. The risk of losing your property is real if you cannot make the payments on time.

Before signing, carefully assess your ability to repay, clarify your purpose for the funds, and decide whether a fixed-rate HEL or a flexible HELOC truly matches your financial needs. To stay updated on how interest rate trends impact your financial decisions, follow the Analysis section at PipRider for more insights.