What is a home equity loan — and it is worth it?

A home equity loan is an installment loan that allows you to tap into your home's equity by using your house as collateral. This type of financing allows homeowners to borrow money for any purpose at comparatively low rates, which is always welcome news. But you always have to exercise caution when borrowing against what's likely your most valuable asset. CNBC Select explains how home equity loans work, when you might want to consider one — and when it's best to look into alternatives.

When you take out a home equity loan, you borrow a lump sum against the equity you own in your home and agree to repay it at a fixed interest rate over a specific period. Generally, terms range from five to 20 years — and sometimes even longer, depending on the lender.

Usually, you can borrow up to 85% of your home's equity — but each lender has their guidelines. Since your home secures the loan, you'll likely qualify for a favorable interest rate. However, the exact terms will depend on your credit history, income and debt-to-income (DTI) ratio.

You receive the full amount at closing and repay it monthly on top of your current mortgage. If you fall behind on your payments, your lender has the right to foreclose on your home. For that reason, it's wise to consider whether a home equity loan is the best choice for your situation before you expose yourself to such risk.

A home equity loan can be a useful financial tool when you need funds to make improvements to your house that can boost its value. When you invest in certain repairs or renovations, such as adding an extra room or upgrading your kitchen, you can increase how much the property is worth — which can positively affect your equity. This way, while you're borrowing against your home, you can anticipate at least some return on investment.

On the other hand, it might not be the best approach to tap into your equity for something that won't increase your wealth. Whether you're planning a vacation or a large purchase, such types of purchases aren't worth putting your home on the line.

Further, a home equity loan is an especially risky endeavor when you need money because you're struggling with bills and day-to-day expenses. Typically, such a problem is only a symptom of a deeper financial issue that requires a more complex, structured approach. A loan by itself might not resolve the situation, and if you fail to pay it back as agreed, you might end up dealing with foreclosure on top of it.

It's also common to use a home equity loan for debt consolidation. It makes sense since these loans have much lower interest rates than credit cards or unsecured personal loans. And while this isn't necessarily a bad idea, you want to make sure you have a solid payoff plan — and plenty of discipline. Otherwise, you risk digging yourself even deeper into debt.

Consider a personal loan

Unsecured personal loans aren't likely to offer you interest rates as low as a home equity loan can, but they're still a viable alternative. A personal loan is a versatile financing tool that can provide access to cash in all of the situations we've described above. Failure to pay back a personal loan can certainly wreak havoc on your credit history — but it's nowhere as bad as the financial and emotional damage caused by losing your house.

CNBC Select ranked LightStream as the best overall lender for personal loans. You can apply for a loan for debt consolidation, medical expenses, home improvement and more. The lender doesn't charge any origination fees, payoff fees or late fees, and you can borrow up to $100,000.

If you're consolidating debt, look into Happy Money. This peer-to-peer lending platform allows you to receive multiple loan offers and compare rates. However, you might need to pay an origination fee.

If you've determined that a home equity loan is the right choice for you, start by shopping around for a lender. It's always a good tactic to gather several offers so you can pick the best available rate and terms.

Remember that each lender has their own guidelines for qualification. Typically, you'll need the following to get approved:

• Sufficient home equity: Lenders typically require that you have at least 20% equity in your home.
• A credit score of 680 or higher: It might be possible to get approved with a lower credit score but you'll likely get unfavorable terms.
• Proof of income: Your lender will most likely want to see you have a regular income that can cover your monthly payments.
• Low DTI: Generally, lenders want to see a ratio of 43% or lower.
• Proof of insurance: Many lenders require that borrowers have homeowners insurance.
• Home appraisal: It's also possible that your lender will request an appraisal to determine how much you'll be able to borrow.

A home equity loan can be a great financing option if you're looking to increase your home value with repairs or renovations. That said, no matter what reason you have for taking this loan, it will put your house on the line. Make absolutely certain you can shoulder the financial responsibility before agreeing to anything.

At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every loan guide is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of loan products. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics.

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