What Is a Home Equity Loan?

Home equity loans are an option homeowners can turn to when in need of extra money to pay for big-ticket items, such as education, home improvements or medical bills.

The practice provides owners with a loan in which their home serves as the collateral, meaning they run the risk of losing the house should they not pay the money back.

Home equity loans are obtained from a lender, similar to a mortgage. Lenders set the dollar limit of the loan based on several factors, including the home's appraised value, the balance owed on the existing mortgage, the ability to repay the loan and credit history, according to the Federal Reserve.

Once approved for the loan, homeowners can typically borrow up to the credit limit whenever they choose during a pre-established fixed time frame. According to the Federal Reserve, some plans require homeowners to borrow a minimum amount each time they draw on the line or keep a minimum amount outstanding. Some plans may also require an initial advance be taken out when the line is set up.

During the life of the loan, some plans set a minimum monthly payment that includes a portion of the amount borrowed, plus accrued interest, while others allow monthly payments of interest only.

Most home equity lines of credit involve variable rather than fixed interest rates, which can change based on the available index used, such as the publicly published prime rate or a U.S. Treasury bill rate. Since the cost of borrowing is tied directly to the value of the index, the Federal Reserves advises homeowners to find out which index is used, how often the value of the index changes and how high it has risen in the past.

Depending on the plan, homeowners either must repay the outstanding amount in full at the end of the loan, or pay it back over a fixed period of time, called a repayment period.

Chad Brooks is a Chicago-based freelance business and technology writer who has worked in public relations and spent 10 years as a newspaper reporter. You can reach him at chadgbrooks@gmail.com or follow him on Twitter @cbrooks76.