How Does a Home Equity Loan Work? (2024)

Home equity products are a great way to tap into the piggy bank that’s hiding in the value of your home. From debt consolidation to home improvement and even big-ticket purchases like a dream vacation, home equity products can be the perfect resource to get the cash you need.

Understanding the basics of home equity loans

The beauty of home equity products is the flexibility that’s available to you as a borrower. Because these products offer multiple terms and repayment options, you can choose options based on your individual needs.

To help you understand how rates, terms, and repayment options work, let’s discuss each aspect as they relate to the different types of home equity products that are available to you.

Equity of your home

Equity can be calculated by subtracting all debts secured by your home from your home’s appraised value. For instance, if your home is worth $275,000 and your current mortgage is $100,000, then you have $175,000 of equity.

Types of loans that tap into home equity

Home equity products available to homeowners include:

• Traditional home equity loan: This type of loan allows you to borrow a fixed amount of money in one lump sum, usually as a second mortgage on your home in addition to your primary mortgage. With a traditional home equity loan, you can expect the interest rate, loan term and monthly payment amount to be fixed.
• Home equity line of credit (HELOC): This product is considered revolving credit because it allows you to borrow money as you need it with your home as collateral. Most HELOC plans allow you to draw funds over a set amount of time known as the “draw period.” At the end of this period, you may be able to renew the credit line and keep withdrawing money, but not all lenders allow renewals. Some lenders require borrowers to pay back the entire amount at the end of the draw period and others may allow you to make payments over another range of time known as the “repayment period.”
• Cash out refinance: This type of home loan allows you to borrow a fixed amount against the equity in your home by refinancing your current mortgage into a new home loan for more than you currently owe, and you take the difference in cash. With a cash out refinance, the additional borrowed amount is combined with the balance of your existing mortgage.

Each home equity option varies slightly, and each variation offers different rates, terms, and repayment options. Please note that while Discover® Home Loans does not offer HELOCs, we can help you find a home equity loan or mortgage refinance with low, fixed rates.

Home equity loan rates

Rates are the amount of interest charged as a percentage of your loan amount paid to the lender for the use of the borrowed funds. Interest rates can be variable, meaning they change over time, or they can be fixed, meaning they stay the same for the duration of your loan term. Your interest rate is the amount you pay to borrow the funds you want.

Home equity loan term lengths

Loan terms vary depending on the type of loan you obtain, and they merely describe the amount of time you have to repay the loan. A home equity loan term can range anywhere from 5-30 years. HELOCs generally allow up to 10 years to withdraw funds, and up to 20 years to repay. A cash out refinance term can be up to 30 years.

How term lengths affect monthly payments

In general, shorter terms mean higher monthly payments and longer terms will allow for lower monthly payments—shorter terms will accrue less interest charges against the loan than longer terms. Longer-term loans will ultimately cost you more.

While the interest rate may stay consistent whether you select a short or long repayment term, spreading the loan out over a longer term will increase the overall amount of interest you will pay against the loan.

For example, if you are taking out a $50,000 home equity loan at 8.99% APR, a 10-year repayment term will cost you $633.11 each month equaling total payments of $75,973 over the life of the loan. The same amount and interest rate with a 30-year repayment schedule will cost only $401.95 each month, but you will pay $144,702.57 against the loan when you complete payments.

Your credit and available equity will typically determine your interest rate offers from lenders, but you will have the ability to select the term of the repayment period. The more you can afford to pay each month, the cheaper your loan will be in the long run.

Home equity loan repayment schedules

Repayment options are the various structures a lender provides for you to repay the borrowed funds. Usually, you will repay your loan monthly, and your loan is paid in full when the term ends. In some cases, as with home equity lines of credit, you might pay the interest only during the term of the loan and pay the full amount of borrowed funds when the loan term ends.

Loan-to-value (LTV) ratio

Loan-to-value ratio is the amount of your mortgage divided by the appraised value of your home. For example, if your mortgage is $100,000, and your home is valued at $275,000 your loan to value ratio is 36%. This means 36% of your equity is mortgaged.

How does a home equity loan work?

• Rates. A traditional home equity loan carries a fixed interest rate for the life of the loan. This means your interest rate will stay the same from your first payment until your last payment. The interest rate for a traditional home equity loan (also known as the APR or annual percentage rate) is based on several factors, including your existing mortgage balance, the value of your home, the term of the loan, the loan amount, your credit history and your income.
• Repayment schedules. When you make payments on a traditional home equity loan, you are paying both the principal and interest on the loan with every payment.
• Term lengths. The term of your loan dictates whether you have a high or low monthly payment. The longer the loan term, the lower the monthly payment. With a traditional home equity loan, once the term of your loan has ended and you made all payments on time, you will have paid off all borrowed funds and interest.

Pros & cons of home equity loans

It’s a good idea to compare the advantages and disadvantages of any loan before you decide to borrow money. If you are planning to tap into your home equity and leverage your home as collateral to secure a loan, there are important benefits and risks to consider.

Pros of home equity loans

• Fixed rates. Home equity loans typically come with fixed interest rates meaning your interest charges won’t change over the life of the loan.
• Fixed monthly payments. With fixed rates, payments for a home equity loan will remain the same over the entire term. This makes it possible for you to budget around predictable monthly payments.
• High borrowing limits. Depending on your lender and the amount of equity you have available in your home, you might be able to borrow a significantly higher sum than you could with an unsecured loan. For example, Discover offers home equity loans for amounts between $35,000 and $300,000.

Cons of home equity loans

• Reduces available equity. When you take out a home equity loan, it reduces the amount of equity available to you, which can limit your ability to use equity financing in the future.
• Risk of foreclosure. As with any home mortgage loan or equity loan, if you cannot make your monthly payments, you put your home at risk of foreclosure.