How does home equity loan payment work? A complete guide

If you’ve been paying down your mortgage for a while, you can sleep easy knowing that you have added security in your life. All those monthly payments you’ve been making could come back to help you later if you need to borrow additional funds for things like consolidating credit card debt, renovating your home, or helping a loved one pay for college. 

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That’s because you build up equity in your home with each monthly payment you make. When you need funds, you may be able to borrow against that equity at a lower rate than most other available financing options, while also benefitting from a steady monthly payment. We’ll explain how home equity loan payments work so you can decide if it’s the right choice for your family.

What is a home equity loan?

A home equity loan is a type of second mortgage. It uses your home as collateral for the loan, and in exchange for that added security, lenders typically offer lower interest rates in return. 

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You’ll receive your funds as a lump sum after getting approved for the loan, and you’ll make steady monthly payments at a fixed interest rate over a term length ranging from one to 20 years. This adds stability to your monthly budget because you always know what your payment will be. 

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The main downsides of home equity loans are the closing costs, which typically range from 2% to 5% of your loan amount. Funding speeds are also relatively slow since you’ll need to go through a full underwriting process, which usually takes between two to six weeks. Lenders can also foreclose on your home if you default on the loan, although this is fortunately very rare. 

How does home equity loan payment work?

Home equity loans are repaid in the same way as other amortizing loans like your mortgage. This means that each monthly payment you make is split up into different portions. One part goes to your lender to cover your monthly interest, while another part goes toward reducing the outstanding balance on your home equity loan. 

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As you pay off the home equity loan, the proportions going toward principal and interest will shift. Early on in your loan term, you’ll have a larger mortgage balance, and more of your payment will go toward interest. Eventually, you’ll reach a tipping point, and more of your monthly payment will start paying down your principal balance. You’ll make fast progress in paying off your debt after this.

What do you need to qualify for a home equity loan?

The requirements to get a home equity loan vary with each individual lender. Some are more accommodating if you have bad credit, for example, while others allow you to borrow against more of your home equity. 

• Credit score: 620 or higher
• Debt-to-income (DTI) ratio: 43% or less
• Combined loan-to-value (CLTV) ratio: 80% to 90%

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A key concept is your CLTV ratio. Lenders use this to calculate how big of a loan you might be eligible for. If a lender has a maximum CLTV ratio of 80%, you’ll generally be able to borrow up to 80% of your home’s value, minus the balance of your mortgage. 

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For example, if you own a home worth $500,000, then you may be able to borrow up to $400,000 (i.e., 80%). If you still owe $300,000 on your mortgage, though, your potential loan amount will be reduced to $100,000. Together, the CLTV ratio of your mortgage and home equity loan would equal 80%: $300,000 on your mortgage, plus $100,000 on your home equity loan.

When does a home equity loan make sense?

Homeowners generally have several financing options available when they need to borrow money. We’ll go into some of those choices next, but it helps to have some idea first of why you might choose a home equity loan over these other options. 

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Here are some factors that could make a home equity loan a particularly good choice for you:

• Stable income: Lenders require steady and consistent income in order to get approved for a home equity loan. A steady income that you can count on also reduces the likelihood you’ll default on the loan in the future and have your home foreclosed on. 
• Low interest rate: If you want to save money on interest, a home equity loan is one of the best options you can choose. These are generally the lowest-rate loans available at any given point in time. 
• Steady monthly payments: Home equity loans are repaid with fixed monthly payments that you can plan for more easily in your budget. You won’t come across any nasty surprises if interest rates rise over time like you might with other equity lending options.
• Home improvement projects: Using home equity loans for home upgrades is a particularly wise choice. The interest you pay on funds used for home improvement projects may be tax-deductible, and you’ll be boosting the long-term value of the very asset you’re using to secure the funds in the first place. 

What are home equity loan alternatives?

It’s important to be aware of all your financing options when you need to borrow money, especially if your monthly payment amount is important. You don’t want to sign up for a payment you can’t sustainably afford, but you also need to apply for the right funding option for your needs. 

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We’ll help you compare some of the other options commonly available to homeowners. 

HELOC

Nine out of 10 homeowners prefer home equity lines of credit (HELOCs) over home equity loans for one simple reason: flexibility. However, you pay for that flexibility with much more variability in your payments. 

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It works like this: rather than getting upfront funding as with a home equity loan, a HELOC allows you to borrow against a pre-set line of credit throughout a five to 10-year draw period, making interest-only payments during this time. When that phase ends, you’ll switch to full monthly payments over a 10 to 20-year repayment period. This can cause big swings in your monthly payment, which are only amplified by the variable rates that HELOCs typically charge. 

HEI

If you’d prefer a lump sum of funds similar to a home equity loan but do not wish to make payments right now, consider a home equity investment (HEI). Unlike a traditional financing solution, an HEI is a partnership with an investor in your home. 

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The investing company will offer upfront funds if you agree to repay them within the next 30 years, along with a slice of your home’s future equity appreciation in lieu of paying interest. You aren’t required to make any payments in the meantime, although you’re free to pay it off early if you choose. 

Cash-out refinance

Taking out a HELOC or home equity loan means you’ll be paying for two separate home loans, if you’re still paying back your mortgage. If you’d prefer to make one monthly payment, consider using a cash-out refinance instead. 

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This allows you to refinance your current mortgage and take out additional funds in the process, so you’ll have a new, larger mortgage. A cash-out refinance loan can be a good option if you’re able to refinance your mortgage at a lower interest rate than you’re currently paying. 

Reverse mortgage

If you’re over age 62 and your mortgage is mostly (or entirely) paid off, another option available to you is a reverse mortgage. This allows you to pull equity out of your home in three ways: as a lump sum, steady monthly payments, or an open line of credit. 

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Your mortgage balance will grow over time — potentially even beyond your home’s actual value — but you won’t be required to make any payments because your lender will use your home to repay the loan after you’re no longer living there. Reverse mortgages can be very useful, but they work differently from any other type of loan, so you’ll be required to undergo counseling before you’re eligible to use them. 

Final thoughts

A home equity loan works much like other installment loan options, offering a good blend of affordable and dependable payment structures. It’s an especially great choice if you’re looking to borrow a lump sum of cash for a particular project, without the need for additional funding later. 

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Home equity loan payments are also much easier to incorporate into your monthly budget since they don’t change over time, thereby reducing your potential for defaulting and, ultimately, having your lender foreclose on your home. That said, it’s still important to ensure you’re able to make your payments consistently over time with a secure income stream. If monthly payments are not a good fit for your budget or lifestyle, you may wish to consider an HEI from Point.