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How do home equity loans work?

A home equity loan can be a cost-effective source of financing for homeowners. Getty Images/iStockphoto

In a time of high inflation, stock market volatility and bank failures, many Americans are looking for ways to finance their expenses, pay off high-interest debt and, in general, make ends meet. Common solutions they turn to may include credit cards and personal loans. But homeowners shouldn't overlook one of their best sources of financing: equity in their homes.

There are several ways homeowners can tap into their home equity, including reverse mortgages, cash-out refinancing, home equity lines of credit (HELOCs) and home equity loans.  Home equity loans, in particular, can be a cost-effective way to access funds for home repairs, renovations and other purposes.

But how exactly do home equity loans work, and when does it make sense to get one? That's what we'll explore below.

Check your home equity loan options here to see if a home equity loan is right for you.

How do home equity loans work?

A home equity loan acts as a second mortgage. It allows you to borrow a lump sum of money based on how much equity you currently have in your home. You pay this amount back over a certain time period (typically, five to 30 years) at a fixed interest rate.

Your home equity is determined by subtracting your outstanding mortgage balance from your home's current market value. The higher your home's value, the more equity you have. 

For example, say you bought your home for $300,000. You make $50,000 in payments, lowering the balance to $250,000. If your home is still worth $300,000 when you apply for a home equity loan, your equity would be $50,000 ($300,000 - $250,000). But if your home's value has increased to $400,000, your home equity would be $150,000 ($400,000 - $250,000).

Lenders typically let you borrow around 80% of your home's equity. So, if your equity is $50,000, you may be able to borrow $40,000. If you wait until your home has appreciated to $400,000, you may be able to borrow $120,000. Taking out a home equity loan when home values are high enables you to maximize your loan amount. That said, regardless of your home's value, a home equity loan may still be a better route than other financing options.

If you think you could benefit from a home equity loan, start exploring your options here.

Are home equity loans worth it?

A home equity loan can be worth it for many reasons. Here are three that stand out.

  • Interest rates are low: A home equity loan is secured by your home, making it less risky for the lender. This security often means lenders offer lower interest rates on home equity loans than you'd received for financing options such as credit cards. The specific interest rate you receive depends on factors like your credit score and income. (Here are some quick tips to improve your credit).
  • The interest rate is fixed: HELOCs often have variable interest rates, which means your payments may fluctuate from month to month. Home equity loans typically offer fixed rates for the loan term, giving you a set monthly payment to budget for and protecting you from interest rate hikes.
  • Interest may be tax-deductible: If you use your home equity loan proceeds for an IRS-approved purpose, you may be able to deduct the interest on your tax return. "Interest on home equity loans and lines of credit are deductible only if the borrowed funds are used to buy, build, or substantially improve the taxpayer's home that secures the loan," the IRS explains. "The loan must be secured by the taxpayer's main home or second home (qualified residence), and meet other requirements." Consult with a tax professional if you're not sure whether you qualify for this deduction.

The bottom line

If you're a homeowner, tapping into your home equity can be a great way to finance everything - from major purchases to debt repayment. If you use the funds to build or make significant improvements to your home, you may even be eligible for a tax deduction. 

Remember to shop around to find the best home equity loan. Compare your options and apply when home values are high. You can also take steps to build your equity quickly to increase how much a lender may give you.

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