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What Is a Home Equity Loan?

So, you’re thinking about getting a home equity loan. Did your lender tell you it can help you get out of debt? Or live well during retirement? Or pay for that renovation you want?

That’s what they say. But the truth is, home equity loans are more likely to hurt your finances than they are to help.

We’ll walk you through what a home equity loan is and how it works. Plus, we’ll look at why home equity loans are bad for you. (Don’t worry—you’ve got other options, and we’ll talk about those too!)

Let’s get started.

What Is a Home Equity Loan?

A home equity loan is a big, fat ball of debt. But before we dig into the loan part, we need to understand home equity.

What Is Home Equity?

It’s your home’s current value minus what you owe on your mortgage.

Here’s an example: Your buddy Mike bought a $300,000 house with 20% down. So, on day one, Mike has $60,000 of equity in his new home.

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Fast forward 10 years. Mike’s been working his butt off to pay down his mortgage, and now he only owes $75,000. Plus, his home’s value went up from $300,000 to $325,000. So his equity looks like this:

$325,000 home value - $75,000 owed = $250,000 equity

So basically, your home equity is the part of your home you own. You build more home equity as you pay down your mortgage and as your home’s value goes up.

Once your mortgage is totally paid off, you have 100% equity. That means you own your house outright, and you’re living the good life with no mortgage. (The grass in the backyard just feels different when it’s paid for, doesn’t it?)

But watch out—a home equity loan takes that away from you!

What Is a Home Equity Loan?

A home equity loan is a second mortgage that borrows money against the part of your home you’ve already paid for. When you borrow against something, that means the lender can take that thing away from you if you can’t pay back what you owe.

And that’s the first reason we can’t stand home equity loans.

After all the hard work you put in to pay your mortgage down (or off), home equity loans put you right back into debt. And the lender can foreclose on your house if you can’t pay!

Even if you repaid part of the loan, the bank can’t just saw off the master bedroom so you can keep the part of the house you own. They take the whole thing—lock, stock and barrel.

But that’s not the only reason home equity loans are the worst. Keep reading!

How Does a Home Equity Loan Work?

Since a home equity loan is a second mortgage, it works almost exactly like your first mortgage. Here’s how getting a home equity loan works:

Step 1: You fill out an application. Seems harmless enough, right?

Step 2: The lender crunches the numbers. If they think you can repay the loan, then you’ll get approved.

Step 3: You and the lender work out the loan details, like how much you can borrow, your interest rate, the length of your loan (aka loan term), your monthly payment and any fees you owe.

Step 4: You pay the closing costs and voilà! You have a home equity loan. (And a giant monkey on your back for the next 10–30 years.)

Once you’re approved for the loan, you’ll get one lump sum payment—which you can spend however you want.

How Much Money Can I Get With a Home Equity Loan?

Lenders decide how much you can borrow based on factors like your credit score and mortgage payment history.

They also look at something called your loan-to-value ratio, which compares how much you owe on the house to how much equity you have.

So, let’s pretend your friend Mike wants a home equity loan. The lender would divide the amount Mike owes by his home’s total value, like this:

$75,000 ¸ $325,000 = 23% loan-to-value ratio

Since Mike has a low loan-to-value ratio, he’s more likely to get approved for a home equity loan. (And since he has a lot of equity, the bank will probably give him a really big loan.)

Most lenders want you to have a loan-to-value ratio that’s 80% or less. If you meet that criteria, they’ll approve you for a loan amount—usually up to 85% of your home equity.

So, if Mike suddenly loses his mind and goes through with the home equity loan, here’s how much he could likely get:

$250,000 equity x 85% = $212,500 loan

That’s a huge chunk of debt! Run away, Mike!

Costs of a Home Equity Loan

Look, lenders don’t give out home equity loans because they want to do you a favor. They give out home equity loans because they’re making money on these things. (The same goes for any type of loan. In fact, if you hear that word, just go ahead and run for the hills. Debt is not your friend!)

Lenders make money by charging you interest—and a lot of them tack on extra fees for good measure. Here are some of the costs you’ll face if you get a home equity loan:

  • Credit check, loan application and home appraisal fees because the ones from your first mortgage no longer count.
  • Origination fees for opening the account, since pressing those computer buttons is so exhausting.
  • Closing costs, just like any other mortgage.
  • Late fees if you miss a payment. (And let us tell you, most lenders are quick on the draw with these suckers. You don’t have to miss it by much to start racking up late fees.)
  • Prepayment penalty since paying your loan off early is a crime. (Okay, you can tell we’re mad about this. Basically, if you pay your loan off early, the lender can’t charge you interest for months or years to come. Many lending companies make up for that by charging you a ridiculous fee to get out of the whole nasty deal. How unfair is that?)

Paying Back Home Equity Loans

Paying back your home equity loan works just like your first mortgage: You’ll pay a set amount each month. Most of that money will go toward interest at first—but as you pay down the principal, you’ll owe less interest.

The average annual interest rate for a home equity loan is around 6%. Some lenders offer lower rates if you let them auto draft your payments from your bank account. But you’re only catching a small break—you’ll still pay plenty of interest over the years.

Speaking of years, that’s how long repaying your home equity loan takes—anywhere from five to 30, to be exact.

What Do People Use Home Equity Loans For?

Besides getting themselves in trouble? Here are some things people (not us) recommend using home equity loans for:

  • Living in retirement
  • Covering emergencies
  • Consolidating or paying off debt
  • Funding big expenses, like tuition, weddings and vacations

But here’s the deal—none of those are good ideas. Here’s why:

  • Retirement. You worked hard your whole life to get where you are. If you get a home equity loan, you’ll have to work hard the rest of your life to stay where you are.
  • Emergencies. Emergencies happen. Kids break their arms, water heaters die, and cars break down. That’s why we teach everyone to save an emergency fund, so you can pay cash for these things as they come up. Imagine facing emergencies with a sense of peace! 
  • Consolidate or Pay Off Debt. Home equity loans don’t help you pay off debt . . . They are debt. It’s just new debt that’s been packaged to sound better than the old stuff. And it doesn’t matter if your home equity loan has a lower interest rate than your other debt. Winning with money is only 20% numbers and knowledge. It’s 80% behavior. If you want to get out of debt, start working the debt snowball method.
  • Cover Big Expenses. If you can’t pay cash for something, you can’t afford it. Period. That goes for huge weddings, dream vacations, college tuition and everything in between. Just because you want those things to make you feel good doesn’t mean you need them. Children do what feels good. Adults devise a plan and follow it. So put on your big kid britches and get to work saving money so you can afford the things you want and feel good about them.

Now, we’re being a little tough on you here. The truth is, we all have a red-faced kid inside, screaming for the things we want. And unless we have a money plan we can actually stick to, it’s pretty darn hard to get that kid to calm down.

That’s why we created Ramsey+, a membership that gives you access to all the content and tools you need to save for emergencies, get out of debt, and build wealth. It’s helped millions of people take control of their money, and it’ll help you too.

Whew! Now that that’s out of our system, let’s get back to home equity loans.

What Are the Types of Home Equity Loans?

As if your average home equity loan wasn’t bad enough, some lenders got the bright idea to make different types of them. And they made other ways for homeowners to tap into their home equity without hearing that scary L-word (loan).

Check it out:

Home Equity Line of Credit (HELOC)

A home equity line of credit (HELOC) is a type of home equity loan that has a revolving line of credit.

It works sort of like a credit card (and you know how we feel about those). You can borrow up to a set limit. Then you have to pay back some of what you owe before you can spend more.

HELOCs are dangerous, because it’s easy to get stuck in that revolving credit line whenever an emergency or new expense pops up. Plus, HELOCs have variable interest rates. So, your rate (and your payment) can go up pretty much whenever the lender wants. 

Reverse Mortgages

Reverse mortgages make us extra mad, because they take advantage of seniors. (No matter how young you feel . . . if you’re 62 or older, that’s you.)

A reverse mortgage lets you borrow one lump sum, a line of credit, or fixed monthly payments against your home’s equity. That last option is why it’s called a reverse mortgage—instead of you paying the bank each month, they pay you.

Many seniors use the monthly payments to cover living expenses in retirement. The problem is that after working your whole life to pay off your home, these payments put you back into debt. And thanks to all those interest charges, you can end up owing more than your home’s worth.

If you can’t pay back the reverse mortgage in your lifetime, the lender can either foreclose or sue your estate after you pass away. That means even if you leave your home to your kids or grandkids, they may have to sell it to pay off your loan. 

Cash-Out Refinance

Okay, let us be very clear: A cash-out refinance is not a home equity loan. But it does let people trade their home equity for debt—which is why we’re talking about it here.

A normal refinance lets you switch from your old mortgage to a new mortgage. Most people refinance to get a better deal—like switching from an adjustable interest rate to a fixed rate. The refi comes with a new loan term and interest rate, but you still owe the same amount on your house.

With a cash-out refinance, you owe the amount left on the original mortgage—and you borrow more money against your home’s equity. So, you’re basically going backwards and defeating the purpose of refinancing, which is to get out of debt quicker.

Pros and Cons of Home Equity Loans

We’ve been bashing home equity loans pretty hard, and there’s a reason for that. Let’s take a look at the pros and cons of home equity loans.

Pros

  • Fixed Interest Rates. You’ll at least have some peace of mind knowing your interest rate won’t change based on the housing market—unless you get a variable-rate HELOC.
  • Tax Deductions. The interest on home equity loans can be tax deductible if you use the money to “buy, build or substantially improve” your main house or second home.1 

Cons

  • It’s risky. As long as you owe money on your house, you’re at risk of losing the roof over your head—and that’s never good. That’s why we teach people to put at least 10–20% down when buying a home and then pay that sucker off as fast as possible! The borrower is slave to the lender, so you want to get out of debt quick.
  • You’ll pay interest out the ears. If you’ve heard anything good about a home equity loan, it probably came from a lender who “just wants to help.” They are helping . . . themselves! The truth is, most lenders want to keep you stuck in a cycle of debt, so they can make money by charging you interest. For example, if you get a 15-year, $50,000 home equity loan at the average 6% interest rate, you’ll pay an extra $26,000 in interest. Ouch!
  • It won’t fix your finances. We don’t care what anyone told you. A home equity loan is not the answer to your money problems. We’ve never talked to a millionaire who got rich by borrowing against their home’s equity—and we talk to a lot of millionaires around here. Our study of 10,000 millionaires shows that they pay cash for big purchases, invest wisely, and stay out of debt. Translation: If you want to build wealth, don’t take out a home equity loan!

What to Do Instead of Getting a Home Equity Loan

For starters, you can walk away the next time someone suggests signing up for one of these monsters. But more importantly, you can take control of your money with a proven plan that actually works.

You are the hero in your story—not some home equity loan lender working in a glass tower downtown. You have the power to change your life. You can do this!

Have More Questions About Your Mortgage?

Talk to a mortgage expert at Churchill Mortgage. They’ve helped tens of thousands of people get mortgages they can actually pay off fast. And if you’re looking to buy a home or refinance, they’ll help you get a mortgage that will work with your financial goals, not against them. That’s why we’re proud to call them RamseyTrusted.

Get in touch with Churchill Mortgage today!

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.

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