Home Equity Loans: How They Work and How to Use Them

In the second quarter of 2021, US homeowners took out $63 billion in home equity loans. Homeowners take out equity loans for a variety of reasons, ranging from home improvements to investments. 

Many homeowners qualify for these loans and don't realize it. Or they don't understand how to take out a home equity loan, so they don't try. 

Want to learn more about how to find out if you qualify for a home equity loan? Or discover the requirements for home equity loans? Keep reading. 


What Is Home Equity? 

Your home equity is the market value of the paid-off amount of your home. To calculate home equity, you need the fair market value of your home and the amount of your unpaid mortgage. 

The more you pay on your mortgage, the more home equity you have. The principal balance of the loan has to decrease for home equity to increase. Paying interest or PMI doesn't increase your home equity. 

When you have a mortgage, you only own the amount of your home that you've paid off. 

For example, say your home’s value is $350,000. And you have $150,000 left on your mortgage. This means you have home equity valued at $200,000. 

How To Build Home Equity

There are a few ways to build home equity. And some of them are out of your control. They include: 

  • Making mortgage payments
  • Completing home improvements
  • Changes in property value
  • Making a large down payment 

Discover more about each in the following sections. 

Making Mortgage Payments

The most obvious and easiest way to increase home equity is to make mortgage payments. The faster the outstanding balance decreases, the higher your home equity will be.

You could even make additional mortgage or principal-only payments to do this faster. 

Completing Home Improvements

Making improvements to your home will increase its value. When the value increases, your home equity will increase even if the mortgage payments are still being paid the same way. Some renovation projects add more value to your home than others. 

Suggested home improvements to increase home equity include: 

  • Painting
  • Energy-saving improvements
  • Landscaping improvements
  • Improved indoor air quality
  • Remove popcorn ceilings
  • Bathroom makeovers
  • Kitchen updates
  • Carpet/floor updates

In addition to these improvement projects, it's important to keep up with regular maintenance and repairs. This will keep your home's value up. 

Changes in Property Value

This is one that's out of your hands. Over time, due to the economy and your location, the property value will rise. There isn't a way to predict when, or if, this will happen.

Researching historical data about your home's location can give you an idea about if it's a possibility. 

Making Large Down Payments 

If you want to start out with high equity, you should make a large down payment. This means you own a higher amount of your home from the beginning. And paying mortgage payments will only increase the amount, so it should build equity faster. 

If you do this, you will have access to home equity loans quicker than you would if you only put down a small down payment. 

What Are Home Equity Loans?

Home equity loans are cash advances in the amount of equity you own. You pay back the borrowed amount plus a fixed interest rate. When you take out a home equity loan, you are placing your home as the collateral for the loan. 

Sometimes home equity loans are called a second mortgage. If you take out a home equity loan and don't pay it back, you risk foreclosure on your home. 

Home equity loans are a way to access more credit for various reasons. Many homeowners use home equity loans to: 

  • Invest in more properties
  • Complete home improvement projects
  • Leverage better interest rates
  • Pay down other debts
  • Pay medical expenses
  • Have cash for an emergency
  • Help a family member 

Home equity loans are a lot like the initial mortgage you took out to purchase your home. There are fees associated with closing a new loan and interest rates may make a home equity loan more costly than it would be worth.  

Interested in learning more about home equity loans? Click to read more about our services. 

How Do Home Equity Loans Work?

Once you apply and are approved for a home equity loan, it will be processed and you're given a lump sum in the amount of the loan. 

You will then pay back a set amount each month for a certain period of time. The terms range from a few years to several. It all depends on the lender and what parameters you want for the loan. 

Each home equity loan varies based on the lender and the borrower. Common questions regarding home equity loans include: 

  1. What are the requirements? 
  2. How much can I borrow? 
  3. What are the costs and fees? 
  4. What's the difference between a home equity loan and a line of credit? 

Do you have additional questions about home equity loans? Or want to get started and see if you're approved? Check out the home equity loan advisors at Farmers Bank to discuss your options.  

Home Equity Loan Requirements

Most lenders require you to own at least 20% of home equity to take out this type of loan. And you need a credit score of at least 620. Although the higher the credit score, the better the interest rate. 

Lenders also look at how much debt you owe and what you have in monthly payments. Your debt-to-income ratio shouldn't be more than 43% if you want to apply for a home equity loan. 

How Much Can You Borrow?

You can take out a loan for the amount of home equity you have, right? 

Not exactly. The amount you can borrow depends on a few factors, including: 

  • The equity you have
  • Your monthly income
  • Your credit history/score

Lenders will calculate and assess this information before giving you an amount. Most of the time, lenders won't let you borrow more than  80% of your home equity. The limit does depend on the lender. 

For example, you have the $200,000 in equity from above. At 80%, you would only be able to take out a loan valued at $160,000. 

Costs and Fees

There are various fees associated with taking out a loan. They vary based on the lender, but they can include: 

  • Appraisal fees
  • Title search fees
  • Origination fees
  • Preparation fees
  • Credit report fees

Fees can vary, ranging from nothing to 6% of the loan amount. It's important to discuss the costs and fees associated with a home equity loan before you initiate the process. 

And you should understand current interest rates. Taking out a home equity loan when interest is high won't be beneficial in the long run. Read more about current mortgage rates at Farmers Bank. 

  • Appraisal Fees

When you take out a home equity loan, the lender has to have an appraisal done on the home. This will help them to understand the market value. And ultimately be a deciding factor in how much your home equity loan is. 

Appraisals generally cost a few hundred dollars. 

  • Title Search Fees

Lenders complete title searches to make sure you own the property. And to verify there aren't any liens or other issues with the title. The cost of a title search varies depending on the company completing it. 

  • Origination Fees

Some lenders charge you to issue the loan. An origination fee isn't always charged, but it depends on the lender. Origination fees can be up to a couple of hundred dollars. 

  • Preparation Fees

Some lenders charge a fee for the preparation it takes to complete your loan. The fees usually cover the lawyers and notaries needed to legalize your loan documents. These fees can be a few hundred dollars considering their nature. 

  • Credit Report Fees 

Since your credit score and debt ratio is an important part of deciding if you get a home equity loan, lenders have to conduct a credit report. Running a credit report isn't very expensive, but the cost is generally passed to you. 

Home Equity Loan vs. Home Equity Credit Line 

A home equity loan is a lump-sum payment with a fixed interest rate. You take out the loan for the specific amount and that's exactly what you receive. You pay interest on the entire amount. 

For example, say you take out the $170,000 home equity loan. You would owe interest on the entire $170,000. But you would also receive that much in cash. 

A home equity line of credit is more like a credit card. You have the option to use it, but you don't have to. And you only pay interest on the amount you do use. 

For example, say you have a line of credit that's valued at $170,000 but you have only used $20,000. You would only pay interest on the $20,000. And the interest rates are adjustable, making payments less predictable than a home equity loan. 

Advantages of Taking Out a Home Equity Loan

There are several benefits to taking out a home equity loan. Not only will you have fixed rates and payment amounts, but you can spend the money however you want. 

And since home equity loans are secured, the interest rates tend to be lower. You can read more about each of these topics below. 

  • Fixed Rates and Payments

Home equity loans tend to have a fixed interest rate and repayment term. This means you'll know exactly what you owe each month and can plan accordingly.

The monthly payments aren't like a mortgage that changes every year because the contributing factors of a home equity loan don't budge. 

  • Freedom to Use Funds as You See Fit

Unlike a mortgage that is exclusively for buying property, a home equity loan doesn't have constraints on what you can use it for. Once you have the funds, you are free to spend as you see fit. 

You could renovate your home, increasing its value significantly. Or you could take the trip you've always wanted to. 

  • Lower Interest Rates

Home equity loans are considered secure credit. And they come with lower interest rates because of this. Many times, the interest rates are much lower than a credit card, giving you the option to consolidate debt strategically. 

Disadvantages of Taking Out a Home Equity Loan

There are also disadvantages to taking out a home equity loan. You'll be stuck with years of payments again. And you'll have to use your home as collateral. 

Not to mention you'll owe fees for closing the loan. It's important to weigh the advantages and disadvantages of taking out a home equity loan before deciding if it's the best decision for you.  

  • Using Your Home as Collateral

This could potentially be a bad situation if something happens and you can't pay the home equity loan back. Using your home as collateral is a risk. You have to consider the pros and cons to decide if it's a risk worth taking. 

  • Closing Costs and Fees

Like a mortgage, you have closing costs and fees when you take out a home equity loan. You could potentially include the fees in your home equity loan, but it would increase the amount owed. 

  • Many More Years of Payments

The relief that comes with paying off a mortgage will be short-lived if you take out a home equity loan. You'll be saddled with many more years of payments, depending on the amount you take out. 

  • Selling Your Home Gets Complicated

If you decide to sell your home and you have a home equity loan, the entire amount will be due. Since the home is collateral, if you sell it, the loan is no longer backed by anything. So, if you have plans to sell your home in the future, a home equity loan may not be the best move. 

How to Select a Home Equity Loan Lender

If you are considering a home equity loan, it would be a good idea to contact your mortgage lender. Sometimes, they can offer you a deal on interest rates or lower fees since you are an existing customer. 

In addition to speaking to your current mortgage lender, here are a few other recommended steps to take when selecting a home equity loan lender: 

  • Research and compare lenders and rates
  • Ask for recommendations from friends and family
  • Make sure the lender offers a home equity loan
  • Understand each lenders' requirement
  • Read reviews from existing customers
  • Know what red flags to look for

Read more about how Farmers Bank can assist you as your home equity loan lender on our blog

  • Research and Compare Lenders

This is the most important step to take. Research lenders, the rates they offer, and the fees associated with working with them. This is the best way to get the best possible deal on your home equity loan. 

  • Ask for Recommendations

If you are looking for a new lender, ask your friends and family which lenders they've had good experiences with. Using someone in your network, or having your contacts refer you, can be very beneficial. 

  • Make Sure They Can Meet Your Needs

Some lenders don't offer home equity loans. Some only specialize in personal or lines of credit. It's important to research and understand what offerings they have. 

It would be a waste of time to contact a lender that can't even provide you with a home equity loan. Make the most of your efforts and don't waste time on lenders who can't meet your needs. 

  • Understand the Requirements and Fees

Each lender has different requirements. Some will take a lower credit score while others won't even consider anything below 700. It's important you find out this information when you conduct research on lenders. 

It would be discouraging to apply and go through the steps to later find out you don't qualify for a simple reason you could have discovered at the beginning. It's important you ask about the fees associated with each lender, too. 

  • Read Reviews 

There is no better way to understand how well a lender will treat you than to look at existing customers. Read online reviews, either on Google or on their social media pages, to see if there are any red flags. 

You don't want to select a lender that has a bad reputation with customers. It won't bode well for your future with them. 

Home Equity Lender Red Flags 

There are several red flags you should avoid when choosing a home equity loan lender. Dishonest lenders are usually very obvious, but sometimes the tactics are more discrete. Red flags include: 

  • Encouraging you to apply for more than you need
  • Changing terms before the contract is signed
  • Asking you to sign blank documents
  • Discourages reading the terms and conditions
  • Lenders who want to set up payments higher than you can comfortably afford
  • Lenders who fudge information on the application 

Discover more about each red flag below. 

  • Encouraging You to Apply for More Than You Need

A responsible lender wouldn't encourage you to apply for more than you need. Taking out more than you need, especially if you state you only want to take out enough for a specific project, isn't a good practice. And you probably don't want to work with someone who is pushing you to do something that could make you owe more. 

  • Changing the Terms Before Signing

Never ever work with a lender who tells you a certain set of terms and then changes it up when it's time to sign the loan documents. This is predatory behavior. And responsible lenders are upfront and honest about terms from the beginning. 

  • Asking You to Sign Blank Documents

Sometimes, predatory lenders will suggest you sign blank documents and they'll fill in the information later. This is a huge red flag! You have no idea what information they'll put on the documents. 

And if you sign ahead of time, you'll be responsible for whatever is written down. This could be disastrous. 

  • Discourages Reading the Terms, Conditions, and Disclosures

An honest and responsible lender wants you to read all loan documents. They want to make sure you completely understand what you are signing and the terms associated with it. 

A predatory lender who discourages reading the documents is a red flag. And should make you wonder what exactly is included in the documents that they don't want you to find out about. 

  • Higher Payments Than You Feel Comfortable With

A responsible lender would never suggest taking out a loan with payments higher than you feel comfortable with. Or payments higher than you can afford each month. 

Lenders should be setting you up for success with your loan. Anything other than that is a red flag and should make you consider choosing a new lender. 

  • Lying on Applications 

Some lenders will fudge the information on the loan application to make sure you get approved. This is another red flag. An honest lender wouldn't put you in a situation to get a loan you aren't able to pay for. 

And lying on a document could lead to a lot of trouble for you in the long run. 

Get Started Today 

Are you interested in seeing if you meet the requirements for home equity loans? Or are you ready to get pre-approved and move to the next step? 

No matter what phase of the process you are in, Farmers Bank is here to assist. Having been in business for more than 100 years, we know how to navigate financial situations with ease. And how to help you get the most out of your loan. 

Learn more about our home equity loans. Or contact us today to speak to a mortgage specialist.