How Home Equity Loans Work

Key Takeaways

• A type of second mortgage, a home equity loan is a fixed-rate loan secured by the borrower’s equity in their home.

• If loan proceeds are used for home repairs or substantial renovations, the loan recipient could qualify for a tax break in the form of a tax deduction.

• Because of the potential tax advantages and competitive interest rates, a home equity loan can also be used to, for example, pay for education, buy an automobile, purchase a second property, or consolidate higher-interest balances.

Compared to credit cards, home equity loans generally have lower interest rates. If eligibility is there, such a loan can be used for anything from home renovations to investments. But just what is a home equity loan, how do such loans work, and how could I use one to invest? Here is that and more.

What are Home Equity Loans?

A type of second mortgage, a home equity loan is a fixed-rate loan that is secured by the borrower’s equity in their home. 

The loan is funded in a lump sum – the amount depends largely on the property’s market value, and generally ranges between $15,000 to $750,000 (up to $1 million for California properties), Typically, lenders are allowed to borrow up to 80 percent to 85 percent of the value of their property, minus existing mortgage balances.

Monthly payments are made over the life of the loan, with most terms ranging from five to 20 years, although 30-year loans are also common.

Note that one can still list their home for sale while they are still repaying their loan. At the sale’s closing, proceeds from the sale will be used to pay any creditors holding liens on the house.

As with other loans, the rate one gets hinges on the lender, the borrower’s income and credit score, and other factors.

Home equity loans are available through various banks, credit unions, online lenders, or another financial institution.

What is Equity?

In real estate, equity is basically how much of one’s home one owns compared to the amount that is owed on the mortgage. For instance, if the home is valued at $300,000 and the mortgage balance is $150,000, then the homeowner has $150,000 in equity.

To calculate how much equity one has in one’s home, subtract the outstanding balance on the home from the house’s approximate value. 

What is the Purpose of Home Equity Loans?

While loan proceeds can be used however one wishes, they often go toward financing home renovations or to cover unexpected expenses. Because of the potential tax advantages and competitive interest rates, a home equity loan can also be used to, for example, pay for continuing education, buy an automobile, cover wedding or business expenses, purchase a second property, or consolidate higher-interest balances.

Such loans frequently represent a more cost-effective way to finance large expenses than personal loans or credit cards with higher interest rates.

Note that most financial advisers recommend that loan proceeds not be used for unnecessary personal expenses such as a luxury vacation.

Types of Home Equity Loans

The two main types of home equity loans are traditional home equity loans and home equity lines of credit.

Traditional home equity loans. With traditional home equity loans, the borrower will have an established repayment term, just as with conventional mortgages. The borrower makes a fixed payment each month that covers the loan’s principal as well as interest. The same as with any mortgage, if the home equity loan is not paid off, the property could be sold to satisfy the remaining obligation.

Home equity lines of credit. Known as a HELOC for short, a home equity line of credit is a line of credit that is secured by the borrower’s home. The borrower gets a revolving credit line that can be used for large expenses or to consolidate higher-interest debt. A home equity line of credit frequently has a lower interest rate than some other loans, and the interest could be tax deductible. 

During what is called the draw period, which typically lasts about a decade, funds can be borrowed up to a lender-set limit. During this period, the borrower is usually only required to make payments toward the interest. Following that comes the repayment period, which usually lasts 20 years, and makes payments each month toward the principal and interest. 

Eligibility for a Home Equity Loan

A big advantage of owning a home is the ability to establish equity, and to borrow against it. When enough equity is built up, the equity can be unlocked via a home equity line of credit.

While eligibility will vary by lender, there are basic criteria for a home equity loan:

• Lenders frequently require the borrower to own at least 15 percent of their home outright.
• Lenders want to see a solid credit score that is at least in the mid-600s.
• A debt-to-income ratio of no more than 43 percent is usually required by lenders, who want to be certain the borrower can afford payments.
• Lenders also prefer that the borrower has a good, steady income, even with ample equity.
• No recent history of late payments, even with a decent credit score, since that can make the borrower look risky.
• Lenders also want to see a low loan to value ratio, which is one’s current mortgage balance divided by the home’s appraised value. In general, a ratio above 80 percent is considered a high loan to value ratio, which could mean higher borrowing costs.

Repayment and Risks

As with all investment products, there are considerations involved with taking out a home equity loan. Those can include:

• Potential foreclosure. This is huge, but only if there is a chance the borrower will not be able to make payments. If contract terms are not agreed upon, foreclosure could ensue. If that happens, the borrower could lose their home.
• Lots of paperwork. The home equity loan application process can be lengthy, and even if all goes well, some lenders charge fees.
• No flexibility. A home equity loan may not be the best choice if the borrower is unsure how much they need to borrow. Since such loans only come in lump sums, there is a risk of borrowing too little. On the other hand, there is a danger of borrowing too much, which will still require repayment.
• The home’s value can decline. There is no guarantee one’s home value will rise markedly over time. In times of economic downturn or if there is sustained property damage from fire or extreme weather, the house may even drop in value.

Potential Benefits of Home Equity Loans

If qualifications can be met, a home equity loan can offer a number of benefits:

• Lower interest rates compared to credit cards and personal loans. This is because home equity loans are secured by the borrower’s house, which renders them less risky for the lender when compared to unsecured debt, which does not require collateral.  A lower rate means a lower overall loan cost.
• Tax favorability. If loan proceeds are used for home repairs or substantial renovations, the loan recipient could qualify for a tax break in the form of a tax deduction.  A licensed accountant tax professional will be able to advise the borrower about this.
• Fixed payments. The monthly payment and rate are fixed, so there are no concerns about those increasing during the life of the loan, unlike with a credit card or home equity line of credit. This could make it easier for the borrower to budget and make monthly payments.
• Longer terms. A home equity loan can have terms of up to 30 years.

Investing with Home Equity Loans

Other uses for a home equity loan can include investments, particularly in “alternatives,” basically any asset classes other than stocks and bonds. Alternatives such as art, real estate, legal finance, and transportation are increasingly popular as investors seek refuge from stock market volatility.

Take the alternative investment platform Yieldstreet — which has the broadest selection of asset classes – on which more than $3.6 billion has been invested to date.

Compared to a traditional investment portfolio of stocks and bonds, which has offered a 6.5% annualized return since 2015, Yieldstreet’s opportunities have returned 9.7% on a net annualized basis over the same period. Over the past 15 years, private market alternatives outperformed stocks in every economic downturn.  

Adding alternative investments to holdings also serves the important purpose of portfolio diversification – having a mix of asset types – which offers reduced overall risk and potentially enhanced returns. In fact, diversification is key to long-term successful investing.  

Alternative Investments and Portfolio Diversification

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Potential risk and tax implications notwithstanding, a home equity loan can be put to a myriad of uses, including for alternatives investments and portfolio diversification.  

Choosing the right type of loan depends on one’s needs and what they plan to use loan proceeds for.