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What Is a Home Equity Loan?
By Aja McClanahan MONEY RESEARCH COLLECTIVE
A home equity loan allows you to convert some of the equity in your home to cash. Often called a second mortgage, this loan is secured by your property. Your home is the collateral you’ll pledge for the loan.
Home equity loans provide funds for homeowners willing to go through the loan application process and take out an additional mortgage on their property. If you’d like to tap into this source of money and learn about how to get a home equity loan, here’s what you should know.
Table of Contents
- How does a home equity loan work?
- Difference between a home equity loan and a home equity loan line of credit (HELOC)
- When is a home equity loan a good idea?
- Home equity loan requirements
- Bottom line to home equity loans
How does a home equity loan work?
Getting a home equity loan is very similar to getting a mortgage. In fact, that’s essentially what you are doing.
You’ll go through an extensive application process, and the bank will use the market value of your home along with the remaining balance on your first mortgage to determine how much they will lend to you.
Once you agree to the amount and sign the required documentation, you’ll get a lump sum from the lender, who will place a second lien on your home to secure the loan. Then you’ll make monthly payments on this loan like you do on your current mortgage.
How is a home’s equity determined?
The amount of equity in your home is a function of the loan balance remaining on your existing mortgage and the appraised value of the home. Suppose you purchased a home for $200,000 and now have a $150,000 mortgage balance after a few years of making loan payments. During that time, the market value of your home has increased and is now $315,000. The amount of equity in your home would be $165,000 ($315,000 minus the $150,000 mortgage balance).
Although you may have an idea of your home’s market value, the final say will come from the appraisal, which will determine the amount you’ll get from your home equity loan.
Banks will usually offer you a home equity loan for around 80%-85% of the equity. This amount is known as the loan-to-value ratio (LTV). If you get a home equity loan with an 80% LTV, the bank will loan you a maximum of $132,000, or 80% of $165,000
Costs of a home equity loan
As mentioned, a home equity loan is similar to a traditional home loan, so it involves many of the same closing costs.
Though you won’t be paying real estate broker commissions, you’ll likely cover other costs: the appraisal fee, bank origination fee, underwriting fees, documentation fees, and other fees from third-party providers such as the title or escrow company. These costs can be between 2% and 5% of the loan amount.
How is a home equity loan repaid?
You’ll repay your home equity loan in the same manner that you pay your mortgage. Typically, you’ll start the repayment period within 30 to 60 days, depending on your closing date. Since the interest rate on a home equity loan is normally fixed, your monthly payments will be constant throughout the loan term.
Benefits of a home equity loan
A home equity loan can be a great source of money that you’d not otherwise have access to. When life circumstances require a large amount of cash, a home equity loan can be a relatively easy-to-access source. It can enable property owners to send their children to college, pay off high-interest debt, fund a startup business, or make home improvements.
Another benefit of tapping into your home’s equity is that the cash you receive is not taxed as income or capital gains. (Whereas if you sold your home, your profits could be subject to capital gains taxes.) Also, if you use your loan proceeds for home improvement purposes, you can deduct a certain amount of interest based on IRS guidelines.
Downsides to a home equity loan
Home equity loans are not free, nor are they cheap. To access this cash, you’ll pay closing costs upfront and then be responsible for making monthly payments for the life of the loan.
A home equity loan will add to your monthly debt obligations. If you’re used to making mortgage payments on a $200,000 loan, and now the total owed on your mortgage and your home equity loan comes to $300,000, you could be putting an extra strain on your finances.
If you experience economic hardship, you could default on your loan—especially if your income hasn’t increased to accommodate the higher monthly payments. Because your home equity loan is secured by your house, delinquent payments could lead to foreclosure and the eventual loss of your property. This is a worst-case scenario, but it’s something to consider when deciding whether to apply.
How to reduce borrowing risks
Even if the bank approves you for a large loan, it’s smart to consider taking a smaller amount so you’re not overwhelmed by higher monthly payments. Another strategy to reduce risk is to use the loan to increase your income. This might mean buying an interest in a business or an income-producing property such as a rental unit.
You can also use your loan to decrease your monthly expenses by consolidating and paying down high-interest debt. Avoid using this money for things that may not offer the best return on your money: pricey vehicles, vacations or other nonessentials may not justify the cost and extra debt burden of a home equity loan. You don’t want to put your home at risk of foreclosure because you decided to buy a boat.
Watch out for dishonest lenders
Make sure you’re dealing with a licensed bank or mortgage broker who will help guide your decision and lead you to the best loan product possible. Lending officers may earn higher commissions on certain home equity loan products, but make sure you are getting the appropriate loan product regardless of how much of a commission your broker may earn.
Also, watch out for lenders who steer you toward fraudulent practices or sneak in extra closing costs. Make sure you understand all the fees in your settlement (closing) statement and question any fees that aren’t clear to you. Don’t be shy about disputing charges you shouldn’t be responsible for. It’s a good idea to have the closing documents reviewed by your personal lawyer (i.e., not the lawyer who represents the lender) who has experience in the real estate field.
Difference between a home equity loan and a home equity loan line of credit (HELOC)
A home equity line of credit (HELOC) is similar to a home equity loan in that you’re getting a loan against the equity in your home. The main difference is that a HELOC is a credit line that you can draw on at your discretion and as your needs change, up to the amount of your credit limit. The process of drawing cash from your line of credit is very similar to writing a check or using a credit card.
Suppose you get a home equity line of credit for $75,000, but at present, you only need $25,000. Instead of making a monthly payment based on the entire $75,000 of available credit, you’ll only make payments on the amount of money you’ve borrowed during the draw period.
Some people use this strategy to fund business ventures that are able to pay down the line of credit quickly after each use – for example, a business that requires inventory that can be sold to pay down the balance of the HELOC.
When is a home equity loan a good idea?
A home equity loan is a good idea if you have a solid plan for the money you’ll borrow and a plan for paying off your debt. Many people use their home equity loans in a way that might improve their financial situation – for example, investing in a rental unit, making home renovations, or paying off higher interest rate credit card debt. However, there are other circumstances where you won’t receive financial returns, but will instead have the intangible satisfaction of putting a child through college, caring for an ill family member, or otherwise keeping commitments to your loved ones. These are very personal decisions, but the risks should be considered along with the rewards.
Home equity loan requirements
Since a home equity loan is very similar to a mortgage, some of its requirements will be similar. The lender will qualify you based on your creditworthiness, income, debt-to-income ratio (DTI), and your employment and income histories.
The lender will evaluate the property that will secure the loan. It will consider the property type and market value to decide how much to lend.
Different lenders have varying requirements and terms that concern your qualifications and the property’s characteristics. For instance, some credit unions may offer a 100% LTV for eligible borrowers. Other lenders may offer a home equity loan on a vacation home.
Other products may accept applicants with lower credit scores, allow borrowers to make interest-only payments, or structure a loan to require a balloon payment at the end of the term. You should connect with a banker or mortgage broker to explore the best home equity loan options for your needs.
Bottom line to home equity loans
Home equity loans can help you reach your financial goals if they’re used wisely. As long as you plan to use your home’s equity in a way that syncs with your financial goals, you should be able to reduce the risk that comes with this type of loan.
As with any financial decision, you should understand what could go wrong and choose your path based on your comfort level. Once you’re ready, reach out to the best mortgage lenders possible and negotiate a home equity loan with terms that meet your needs.
Aja McClanahan is a writer that covers personal finance and a number of related topics. Her work and personal story of paying down over $120,000 in debt have been featured in publications around the web including sites like Money, CreditCards.com, Business Insider, Inc., Experian and many others.