With record-breaking home appreciation seen throughout the pandemic, most homeowners have more equity in their homes now than they did two years ago. If you need access to funds for a renovation project, education expenses or even debt consolidation, tapping into your home's equity could provide you with a lower-rate financing option. A home equity loan, which lets you borrow money against the equity you've built in your home, provides you with a lump sum of cash at a fixed interest rate. 

Home equity loans may be particularly appealing in the current economic climate because interest rates keep rising while home equity loan rates remain fixed. Right now, average home equity loan rates are at 7.8%, according to Bankrate, CNET's sister site. The Federal Reserve increased its benchmark interest rate for the sixth time this year at its November meeting in an attempt to combat rising inflation, which also pushed up mortgage rates. Home equity loans, however, still tend to offer lower interest rates than other types of loans because your home serves as collateral to secure the loan. That's a significant benefit for anyone looking for financing at a time when it's uncertain how much higher rates will rise. 

This type of financing may make sense if you own your home and have at least 15% to 20% of equity built up in it. Unlike a home equity line of credit, or HELOC, you'll receive the sum of the loan upfront in one lump payment if you're approved.

While a home equity loan is a low interest rate financing option, it's not without risk. When you secure the loan, your home acts as collateral, which means you could lose your home if you're unable to repay what you borrowed. It's important to carefully consider whether a home equity loan is right for you before applying for financing.

Here's what you should know about home equity loans, how they work, who they're best suited for and how they compare to other loan options.

What is a home equity loan?

A home equity loan offers you a lump sum of cash that you borrow against the equity built in your house. Tapping into your home's equity means you're borrowing against the mortgage payments you've already made -- it won't replace your existing mortgage payment -- it's a new loan that you'll repay monthly, along with your existing home loan.

Most lenders require that you have 15% to 20% of equity in your home to secure a home equity loan. To determine how much equity you have, subtract your remaining mortgage balance from the value of your home. For example, if you have a $500,000 mortgage and you owe $350,000 on it, you have $150,000 in equity. To calculate the percentage, divide $150,000 by your home's value of $500,000 and you'll have 30% of equity available in your home. Lenders will typically let you borrow around 80% to 85% of your home's equity for a home equity loan. So, in this example, you can borrow up to $120,000 to $127,500. 

A standard repayment period for a home equity loan is between five and 30 years. Under the loan, you make fixed-rate payments that never change. So, if interest rates go up, your loan rate remains locked in. 

Current home equity loan rate trends

One of the benefits of home equity loans is that they typically have lower interest rates than personal loans or credit cards. Now, borrowers with excellent credit and sufficient equity can secure home equity loans with interest rates as low as 5% to 6%, according to Bankrate.

One potential downside of a home equity loan is that if your property value goes down for any reason, you could end up underwater on your loan. This happens when the balance of your loan becomes higher than the value of your home. That's what happened to millions of Americans during the 2008 financial crisis. Today, however, there's less risk of your home's value decreasing below your home equity loan amount. Home prices have appreciated more than 40% across the US since the beginning of the pandemic, and it seems unlikely that they'll go down in a significant way anytime soon.

Pros of a home equity loan 

• Fixed-rate payments: Your monthly payment will never change even if interest rates rise.
• One lump sum of cash: You receive the entire loan upfront in one disbursement.
• Low interest rates: It has a lower interest rate than other types of personal loans or credit cards. 
• Tax deductible interest: If you use it for home renovations, you can deduct the interest from your taxes. 
  

 Cons of a home equity loan 

• Using your home as collateral: If you fail to make your payments or default on your loan, your lender can foreclose and take ownership of your house.
• It can take longer to receive the funds: Receiving a home equity loan can take more time than it can for a personal loan, for example. 
• Closing costs are expensive: These costs can range anywhere from 2% to 5% of the loan. 
• Your home's value could decrease after receiving your loan: Although home values aren't expected to decrease significantly any time soon, if your home's value were to drop below your home equity loan amount, you'd have what is known as "negative equity" -- owing more than your home is worth. So, if you were to sell your home, you won't receive enough money from a seller to help pay off your loan balance.

Home equity loan vs. HELOC

Home equity loans and HELOCs are similar, but have a few key distinctions. Both let you draw on your home's equity and require you to use your home as collateral to secure your loan. The two major differences are the way you receive the money and how you pay it back. 

A home equity loan gives you the money all at once as a lump sum, whereas a HELOC lets you take money out in installments over a long period of time, typically over ten years. Home equity loans have fixed-rate payments that will never go up, but most HELOCs have variable interest rates that rise and fall with the economy and overall interest-rate trends. 

A home equity loan is better if:

• You want a fixed-rate payment: Your monthly payment will never change even if interest rates rise.
• You want one lump sum of money: You receive the entire loan upfront with a home equity loan.
• You know the exact amount of money you need: If you know the amount you need and don't expect it to change, a home equity loan likely makes more sense than a HELOC.

A HELOC is better if:

• You need money over a long period of time: You can take the money as you need it and only pay interest on the amounts you withdraw, not the full loan amount, as is the case with a home equity loan.
• You want a low introductory interest rate: Although HELOC rates may increase over time, they also typically offer lower introductory interest rates than home equity loans. So, you could save money on interest charges.

Home equity loans vs. cash-out refinances

A cash-out refinance is when you replace your existing mortgage with a new mortgage, typically to secure a lower interest rate and more favorable terms. Unlike a traditional refinance, though, you take out a new mortgage for the home's entire value -- not just the amount you owe on your mortgage. You then receive the equity you've already paid off in your home as a cash payout. 

For example, if your home is worth $450,000 and you owe $250,000 on your loan, you would refinance for the entire $450,000, rather than the amount you owe on your mortgage. Your new cash-out refinance home loan would replace your existing mortgage, and then offer you a portion of the equity you built (in this case $200,000) as a cash payout. 

Both a cash-out refi and a home equity loan will provide you with a lump sum of cash that you'll repay in fixed amounts over a specific time period, but they have some important differences. A cash-out refinance replaces your current mortgage payment. When you receive a lump sum of cash from a cash-out refi, it is added back onto the balance of your new mortgage, usually causing your monthly payment to increase. A home equity loan is different -- it does not replace your existing mortgage and instead adds an additional monthly payment to your expenses. 

A home equity loan is better if:

• You do not want to pay private mortgage insurance: Some cash-out refinances require PMI, which can add hundreds of dollars to your payments, but home equity loans do not.
• You can't complete a refinance: With rates rising, it's possible that your mortgage rate is lower than current refinance rates. If that's the case, it likely won't make financial sense for you to refinance. Instead, you can use a home equity loan to only take out the money you need, rather than replacing your entire mortgage with a higher interest rate loan.  

A cash-out refinance is better if:

• Refinance rates are lower than your current mortgage rate: If you can secure a lower interest rate by refinancing, this could save you money in interest, while providing access to a lump sum of cash. 
• You only want one monthly payment: The amount you borrow gets added back to the balance of your mortgage so you only make one payment to your lender every month.
• Less stringent eligibility requirements: If you don't have great credit or you have a high debt-to-income ratio, or DTI, you may have an easier time qualifying for a cash-out refi compared to a home equity loan. 
• Lower interest rates: Cash-out refinances sometimes offer more favorable interest rates than home equity loans.

Who qualifies for a home equity loan?

Although it varies by lender, to qualify for a home equity loan you're typically required to meet the following criteria:

• At least 15% to 20% equity built up in your home
• Adequate, verifiable income and stable employment
• A low debt-to-income ratio, or DTI -- preferably 36% or less, but no higher than 43%
• A minimum credit score of 620 (700 or higher is preferred and will get you better rates)

How to choose a lender

You'll want to consider what type of financial institution best suits your needs. In addition to mortgage lenders, financial institutions that offer home equity loans include banks, credit unions and online-only lenders.

One option is to work with the lender that originated your first mortgage as you already have a relationship and history of on-time payments. Many banks and credit unions also offer discounted rates and other benefits when you become a customer. 

Some lenders offer lower interest rates but charge higher fees (and vice versa). What matters most is your annual percentage rate because it reflects both interest rate and fees.

Make sure the specific terms of the loan your lender is offering makes sense for your budget. For example, be sure the minimum loan amount isn't too high and don't withdraw more funds than you need. You also want to make sure that your repayment term is long enough for you to comfortably afford the monthly payments. The shorter your loan term, the higher your monthly payments are likely to be. 

No matter what, it's important to talk to numerous lenders and find the best rate available. 

How to apply for a home equity loan

Applying for a home equity loan is similar to applying for a mortgage in that you need to qualify with a lender or bank who's willing to lend you the money.

1. Interview multiple lenders to determine which lender can offer you the lowest rates and fees. The more companies you speak with, the better your chances of finding the most favorable terms.
2. Have at least 15% to 20% equity in your home. If you do, lenders will then take into account your credit score, income and current DTI to determine whether or not you qualify and your interest rate.
3. Be prepared to have financial documents at the ready such as pay stubs and Form W-2s as well as proof of ownership and the appraised value of your home.
4. Once you submit your application, the final step is closing on your loan. In some states, you'll have to do this in person at a physical branch.

FAQs

More mortgage tools and resources

Use CNET's mortgage calculator to help you determine how much house you can afford. The CNET mortgage calculator factors in variables such as the size of your down payment, home price and interest rate to help you understand how much of a difference even the slightest increase in your rate can make in the amount of interest you'll pay over the lifetime of your loan.

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Correction, 10:45 a.m. PT, Nov. 17: An earlier version of this article incorrectly stated the average home equity loan rate. The correct rate is 7.4%.