Home equity loans: how they work and when one beats a HELOC

What a home equity loan is

A home equity loan is a closed-end loan secured by your home. Closed-end means you borrow one set amount, once. When you pay it down, you cannot draw that money again. If you need more later, you start a new loan.

Equity is your home's current value minus what you still owe on it. The Consumer Financial Protection Bureau (CFPB) describes a home equity loan as borrowing against that equity, with the home as collateral, paid to you as a lump sum.

Is a home equity loan a second mortgage?

Yes, if you already have a mortgage. The CFPB says that when you have an existing mortgage, a home equity loan or a HELOC is considered a second mortgage that you pay in addition to your first. The lender records a second lien on the property. Your first mortgage keeps its rate, balance and payment.

How payout and repayment work

• Payout: the full loan amount is funded at once, after closing. Depending on the lender and the purpose, it may go straight to a contractor or to creditors, or be deposited to you.
• Interest: it starts on the full amount from the day the loan funds, because you have the full amount from day one.
• Payments: on a fixed-rate home equity loan, the rate and the principal-and-interest payment stay the same for the life of the loan. Each payment covers interest plus part of the balance, so the loan pays down on a schedule.
• Term: set in years. Available terms vary by lender and program.

Home equity loan vs HELOC

The core difference: a home equity loan gives you one lump sum with set payments, and a HELOC gives you a credit line you draw from as you need it. A HELOC works more like a credit card secured by your house. You can borrow, repay and borrow again up to your limit during the draw period.

Most HELOCs carry a variable rate, so the payment moves with the rate and with how much you have drawn. After the draw period ends, you can no longer borrow and you repay what is left. The CFPB notes that payments in that repayment period are usually much higher than during the draw period.

One more HELOC point worth knowing: the CFPB says a lender can reduce or freeze a HELOC line if your home's value drops significantly or your finances weaken. With a home equity loan, the money is already in hand once it funds.

When each one tends to fit

Match the product to the shape of the cost. A home equity loan suits one known cost you can price today. A HELOC suits costs that come in stages or that you cannot pin down yet.

A home equity loan usually fits when

• You have a signed bid for one project, like a roof, a septic system or windows, and the money goes out all at once.
• You are paying off a set list of balances in one move and want one predictable payment in their place.
• You want a payment that stays the same, for budgeting.
• You would rather not have an open line of credit sitting against the house.

A HELOC usually fits when

• You are doing a phased remodel and paying contractors as work is finished.
• The final cost is uncertain, so you want room without paying interest on money you have not used.
• You expect a series of costs over several years, like tuition paid each semester.
• You are comfortable with a payment that can move with rates.

Some homeowners use both: a home equity loan for the known piece and a smaller HELOC for the unknowns. That means two applications and two sets of costs, so ask a loan officer to price it both ways.

How much equity you need, and how lenders size the loan

Lenders size a home equity loan with combined loan-to-value, or CLTV. CLTV is everything secured by the home, divided by the home's value. Fannie Mae's guidelines, for example, add the first mortgage, any drawn HELOC balance and any closed-end second loans, then divide by the property value. Each lender sets its own CLTV limit, and limits vary by lender, program, occupancy and credit.

Worked example (hypothetical numbers)

1. 1Hypothetical home value: $500,000. Hypothetical first mortgage balance: $250,000.
2. 2Equity: $500,000 minus $250,000 is $250,000.
3. 3Suppose a lender allows total liens up to 85% of value. 85% of $500,000 is $425,000.
4. 4Subtract the first mortgage: $425,000 minus $250,000 leaves up to $175,000 as the largest home equity loan that lender would consider.
5. 5If the same lender capped it at 80% instead, the ceiling would be $400,000 minus $250,000, or $150,000.

That ceiling is a cap, and you do not have to use all of it. Your income, debts and credit still decide what you qualify for, and the appraisal sets the value the lender actually uses. Because the CLTV limit sits below the home's full value, you keep some equity in the property after the loan.

Home equity loan requirements

Lenders look at the same core things for a home equity loan that they look at for any mortgage: equity, credit, income and debts, and the property itself. Exact minimums vary by lender and program.

• Equity: enough room under the lender's CLTV limit, based on a current valuation of the home.
• Credit: your credit history and score affect both approval and pricing.
• Debt-to-income (DTI): the CFPB defines DTI as all your monthly debt payments divided by your gross monthly income. The new payment counts in that math.
• Income you can document: pay stubs and W-2s, or tax returns if you are self-employed.
• Mortgage history: a first mortgage paid on time helps.
• Occupancy: a primary residence is the most widely available. Some lenders also offer second homes.

Home equity loans on a rental property

Some lenders offer home equity loans on investment properties and some do not. Where they are offered, expect a lower CLTV limit and stricter qualifying than on a primary residence. Lenders may also look at the rental income and the property's own payment history. Ask up front which occupancy types a lender will consider before you pay for an appraisal.

Costs to ask about

A home equity loan has upfront costs, and the CFPB advises comparing those costs along with the monthly payment. Ask each lender to put these in writing so you can compare offers line by line.

• Application or origination charges
• Appraisal or other valuation fee
• Points, if any are charged to buy down the rate
• Title search, title insurance and recording fees for the new lien
• Attorney or settlement fees where your state requires them
• Any charge for paying the loan off early, and how it works
• Whether costs are paid in cash at closing or added to the loan amount

Compare the annual percentage rate (APR) from each lender too. It folds certain costs into one figure, which makes offers easier to line up.

The process, step by step

A home equity loan follows the same basic path as a first mortgage, with fewer moving parts because your first mortgage stays put.

1. 1Decide the amount and the purpose. Get the contractor bid or the payoff figures first, so you borrow what the job needs.
2. 2Check your equity. Pull your current mortgage statement and get a rough idea of the home's value.
3. 3Talk to a loan officer. Confirm the lender offers a closed-end home equity loan on your occupancy type, and ask for the CLTV limit and a cost estimate.
4. 4Submit your application and documents. The lender pulls credit and reviews income and debts.
5. 5Valuation. The lender orders an appraisal or another valuation method its program allows.
6. 6Underwriting and approval. The lender confirms the numbers and issues final terms.
7. 7Review your disclosures. Check the rate, the payment, the term and every cost before you sign.
8. 8Closing. You sign the note and the security instrument for the second lien.
9. 9Right to cancel, then funding. For a loan secured by your primary residence, federal rules generally give you until midnight of the third business day after closing (and after you receive the required notice and disclosures) to cancel in writing. Funds go out after that window.

What to have ready

• Your most recent first mortgage statement
• Homeowners insurance declarations page
• Recent pay stubs and W-2s, or recent tax returns if self-employed
• Recent bank statements
• Photo ID
• Contractor bids or a list of the balances you plan to pay off
• HOA contact details, if you have an association
• Leases and rental history, if the property is a rental

Risks to weigh before you sign

The biggest risk is simple: your home secures the loan. The CFPB is direct about it. If you cannot repay, the lender could foreclose.

• A second lien on your home. You will have two mortgage payments. When you sell or refinance, both have to be paid off.
• Closing costs. They reduce what you net from the loan, and on a smaller loan they take a bigger bite.
• Borrowing more than you need. Interest runs on the full amount from funding, including any cushion you do not spend.
• Less room if values fall. Owing more against the house leaves you less cushion if prices drop and you need to sell.
• Turning unsecured debt into secured debt. Credit card and personal loan balances are not tied to your house. Fold them into a home equity loan and they are.

Using a home equity loan for debt consolidation

Consolidation can replace several due dates with one fixed payment. The total you owe stays the same, and the home now secures it. The CFPB warns that using home equity to pay off debts may put your home at risk, and suggests talking with a nonprofit credit counselor first. If the spending that built the balances has not changed, the cards can fill back up while the home equity loan is still being repaid. Go in with a plan to keep them paid down.

Tax note: deductibility depends on how you use the money

Interest on a home equity loan may be deductible only in limited cases. IRS Publication 936 says interest on a loan secured by your home is deductible only to the extent the money was used to buy, build or substantially improve the home that secures the loan. Use it to pay off credit cards or buy a car, and that portion of the interest is generally not deductible.

Overall limits on deductible mortgage debt also apply, and tax law changes. Check the current version of IRS Publication 936 and any recent legislation, and talk with a tax adviser about your situation. Nothing in this guide is tax advice.

When a cash-out refinance makes more sense

A cash-out refinance replaces your first mortgage with a new, larger one and pays you the difference. You end up with one loan and one payment. A home equity loan leaves your first mortgage alone and adds a second.

The deciding question is usually your current first mortgage rate. If that rate is worth keeping, a home equity loan or HELOC lets you take equity out without touching it. If it is not worth keeping, refinancing the whole balance can make more sense, because you replace the first mortgage and take cash in the same transaction.

A cash-out refinance tends to fit when

• Your first mortgage rate is not one you want to keep.
• You want to change the first mortgage anyway, for example to remove someone from the loan or move from an adjustable rate to a fixed rate.
• You prefer a single mortgage payment over two.

The trade-offs: the CFPB notes that closing costs on a cash-out refinance are generally higher, it may take longer to pay off your mortgage, and the new rate may be higher than your current one. Run both options on paper, with the full cost of each, before you choose.