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Consumers are sometimes concerned they won't be able to borrow enough for large purchases, such as a wedding or family vacation. But homeowners, who can tap some of their home equity to borrow, are faced with their own rightsizing challenges. Specifically, they'll contend with lenders who will only issue a loan above a certain amount—an amount that may exceed the borrower's immediate need.
Why Does Home Equity Matter?
Home equity is the current market value of a home minus the balance remaining on the mortgage. For example, if you own a property valued at $400,000 and have a $240,000 mortgage balance, you have $160,000 in home equity ($400,000 - $240,000). As you continue to make mortgage payments, your equity increases.
The amount of home equity matters as it informs how much lenders are willing to lend to you. Typically, the loan-to-value ratio—the total balance of all loans based on the property—can't exceed a certain percentage. So, in the example above, you could borrow up to $320,000 if the lender's maximum loan-to-value ratio is 80%.
Homeowners built a lot of equity in 2021. According to Corelogic, a housing industry observer, homeowners increased their home equity by an average of $55,000 in 2021. That equity provides a potential funding source for borrowers in need of cash.
Ways to Borrow From Home Equity
There are numerous ways to borrow against the value of your home. Each has certain advantages, and current interest rates on various loans can help inform your decision.
Cash-Out Refinance
Until recently, one popular way to access home equity was a cash-out refinance. This method uses a new, larger mortgage loan to pay off the existing mortgage with any leftover funds going to the borrower. The cash-out portion could generally be any amount a lender would be willing to loan a borrower based on the home's market value.
But with mortgage interest rates rising sharply in 2022, this is quickly becoming an unattractive option for many homeowners, as the rate on the new mortgage will likely be higher than the current mortgage. In addition, closing costs may be significantly more for cash-out refinances than other types of home equity loans, which can affect its usefulness when borrowing a small amount.
So for homeowners who already have a mortgage but aren't interested in refinancing, there are two major choices: a home equity loan or a home equity line of credit (or HELOC). Both use the property as collateral, but they differ in a few key ways.
Home Equity Loan
A home equity loan is a fixed-rate installment loan that allows you to borrow against a portion of the equity in your home. It works much like a first-lien mortgage; the homeowner makes payments on the existing mortgage and the home equity loan.
Home Equity Line of Credit
Like a home equity loan, a HELOC allows a homeowner to borrow against the value of their home. HELOCs work somewhat differently than home equity loans, however. Instead of borrowing a lump sum you repay over time with interest, a HELOC allows you to borrow only what you need, with interest applied only to what you borrow—not the entire line of credit.
Like credit cards, HELOCS have variable annual percentage rates based on the prime rate. So borrowing may become more expensive if interest rates continue to rise.
In addition, there are expiration dates for HELOC loans. Typically, you can borrow against the line of credit for a set number of years—often 10—and have up to 15 years to fully repay the line of credit.
Finally, there are minimum and maximum amounts a borrower can draw from a HELOC. The maximum is, as previously noted, a percentage of one's combined loan-to-value ratio. But there are significant minimums as well. Typically, most lenders won't permit draws of less than $10,000 at any one time.
HELOCs may come with an introductory offer—just like credit cards—that may offer the borrower lower borrowing costs in exchange for immediately drawing from their HELOC.
Minimum Borrowing Limits for Home Equity Loans and HELOCs
Home equity loans and HELOCs typically have a high minimum. Among major banks, the minimum as of April 2022 was $10,000, with a maximum combined loan-to-value of 80%. But some lenders expect a minimum loan of $35,000, and even lower loan-to-value ratios, which for some potential borrowers may limit their ability to obtain a loan.
Some banks aren't currently accepting HELOC applications, citing current market conditions.
Consider Personal Loans as an Alternative to Home Equity
If a home equity loan or HELOC isn't right for you, or your preferred lender isn't currently offering them, you might instead go with a personal loan. Terms may resemble a home equity loan—both have fixed-rate APRs and fixed monthly payments—but there are differences.
Personal loans are unsecured, meaning that the loan isn't based on collateral, like a home. Some lenders offer personal loans without origination costs, but even if they do, they won't be as much as closing costs on home equity loans, which can cost several thousand dollars for larger loans.
You'll also receive funding faster with a personal loan if time. When borrowing against your home's equity, it can take several weeks before an initial funding or draw takes place. And you'll be able to precisely dial in the amount you borrow with a personal loan, instead of being limited to the significantly high minimum draws of HELOCs and home equity loans.
Keep in mind that APRs are usually higher for personal loans than home equity loans. And a personal loan is repaid over a slightly shorter time period, typically three to five years.
You can view your personal loan options through Experian's personal loan marketplace.
Risks of Home Equity Loans and HELOCs
Like a primary mortgage, home equity loans and HELOCs use your property as collateral, which means you can lose your home if you don't keep up with payments. This is obviously a significant financial risk, which is why tapping your home's equity might not be the right choice in some circumstances.
How you use home equity loan or HELOC funds may also impact you at tax time. While the IRS currently permits deductions on home equity loan interest, the proceeds of the loan must be used for home improvement. Otherwise, home equity interest payments won't have the tax advantages of a primary mortgage, such as deducting interest payments from your income taxes.
When deciding how to borrow, weigh the pros and cons of all your options, and be sure to make every payment on time. Missing a debt payment can result in harm to your credit score that can make it harder to borrow in the future. You can monitor your credit health for free through Experian.