A home equity loan could help you get the money you need for a renovation or emergency — here's how they work

Your "home equity" refers to how much your home is worth minus the remaining balance on your mortgage. If your house has increased in value since you purchased it or you've paid off a solid portion of your mortgage (or a combination of both), you could have a significant amount of equity built up in your home.

Home equity is a valuable tool that gives you a lot of financial options. On one hand it means that you would net a profit if you were to sell. But what if you have no interest in moving? In that case, you may still be able to tap your home equity by taking out a home equity loan.

Whether you're looking to fund a home renovation, pay for unexpected medical bills, or consolidate debt, borrowing against your home's equity could be a good way to get your hands on a large chunk of cash. But there are some risks that you'll also want to consider. Here's how it all works.

How does a home equity loan work?

Home equity loans and lines of credit (HELOCs) are both considered second mortgages. After you take out a home equity loan, you'll have two loans that use your home as collateral —- your original mortgage and the home equity loan.

The first step towards deciding if this type of loan would be a good option for you would be to calculate how much you'd be able to borrow. To estimate your home's current value, you can use online tools like Zillow, Redfin, or Realtor.com. Or, to get a more accurate estimate, you may want to give a local real estate agent a call. 

Once you've estimated your home's value, subtract your mortgage balance to calculate your home equity. Let's say your home is worth $400,000 and you owe $160,000 on your mortgage. In this case, you'd have $240,000 of equity built up in your home and a 40% loan-to-value ratio.

Many lenders limit homeowners to a combined loan-to-value ratio of 80%. In this example, 80% of $400,000 is $320,000. When you subtract your remaining $160,000 mortgage balance from $320,000, you find that you could potentially borrow up to $160,000 with a home equity loan ($320,000 - $160,000 = $160,000).

What are the differences between a home equity loan and a line of credit (HELOC)?

While the terms "home equity loan" and "home equity line of credit" (HELOC) are often used interchangeably, they're actually two different types of home equity debt. With a home equity loan, you borrow the entire amount at one time in a lump sum. Then, you'll immediately begin making equal monthly installment payments to repay the loan. 

With a HELOC, you receive a revolving line of credit as opposed to a lump sum loan amount. HELOC borrowers are approved for a maximum loan amount that you can borrow against as needed during the draw period (usually up to 10 years). As you pay your balance down, more of your available credit becomes available to borrow against. 

During the draw period, HELOCs work, in many ways, like credit cards. You have complete control of how much you borrow and you can borrow against your credit limit multiple times. However, after the draw period ends, you won't be able to borrow any more and you'll start making equal monthly payments.

Home equity loans tend to come with fixed interest rates while HELOCs generally use variable rates. A home equity loan could work well if you know exactly how much you need to borrow and want to lock down your rate. But a HELOC could be a better option if you want flexible access to your home's equity over time. 

What are the borrower requirements for a home equity loan?

It may seem obvious, but your lender will want proof that you actually have equity in your home before they'll approve you for a home equity loan. Most lenders will send a home appraiser to determine what your home is worth and how much equity you have available to borrow against.

If you do, in fact, have equity in your home, the borrower requirements will essentially be the same as what lenders use for first mortgages. That means most lenders will require a credit score of at least 620 and a debt-to-come ratio below 43%. Proof of employment and income records will likely be required as well.

What are the benefits and risks of a home equity loan?

The fact that a home equity loan would be secured by your home limits your lender's risk. And, because of this, they may offer better interest rates or easier borrower requirements with home equity loans than unsecured forms of debt like credit cards or unsecured personal loans.

In addition to getting access to attractive rates and terms, you may be able to get your hands on a lot more cash with a home equity loan than you'd be able to borrow with an unsecured loan. And homeowners are allowed to deduct the interest paid on a home equity loan as long as the money is used for home improvement.

The downside to taking out a home equity loan is that you could lose your home if your financial situation changes and you aren't able to make your payments. This is one reason why it can be a dangerous move to consolidate unsecured debt (like credit card debt) with a home equity loan. 

Credit card issuers can't take your home without first winning a judgment in court. But if you pay off your credit cards with a home equity loan, your home would then be at risk if you were to default on the loan. This doesn't necessarily mean that moving high-interest credit card debt to a lower-interest home equity loan is always a bad move. But you'll want to carefully weigh the pros and cons.

While consolidating unsecured debt can be a risky use of home equity loan funds, using the money to renovate and increase the value of your home can be a really smart move. Other good reasons to take out a home equity loan could include paying for college, starting a business, or covering an emergency expense.

How can homeowners shop for a home equity loan?

Before you start the home equity loan shopping process, you'll want to check your credit. You can check your credit score for free with tools like Credit Karma or Credit Sesame. And at AnnualCreditReport.com you can check your credit reports with all three credit bureaus for free once per week through April 2021.

If you see errors on one of more of your credit reports, you'll want to dispute them to have them removed before you start submitting loan applications. 

You can shop for home equity loans at most banks, credit unions, or with online lenders. Many will allow you to check your pre-qualified rate without impacting your credit score. But even if a few hard credit inquiries hit your credit report within the span of a few weeks, the credit scoring models will generally consider them as one inquiry.

What are some alternatives to a home equity loan?

If you're sure you want to tap your home's equity, but you're not thrilled about the idea of having two loan payments to manage each month, you may want to consider a cash-out refinance instead. 

You'll typically need to meet the same equity requirements if you go this route. But after completing the cash-out refinance, you'd be left with only one monthly payment to worry about instead of two. 

If you're looking for a way to consolidate high-interest debt without putting your home at risk, you may want to apply for a 0% balance transfer card. Or if you'd prefer to borrow a lump sum that repay over time, unsecured personal loans often offer better interest rates than credit cards.

This article was written by Clint Proctor from Business Insider and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.