If you own a home, chances are good that you have heard the term “home equity loan” bandied about on occasion. Perhaps you’ve seen it in advertisements, or maybe taking out such a loan has been suggested to you as a means of paying for large expenses, such repairs or renovations to your home or college tuition for a loved one. So just what is a home equity loan and how does one work?
A home equity loan is a type of loan that allows homeowners to borrow against the equity they have built up in their homes. So, what exactly is home equity and how is it built up?
Home equity is the share of your home that you own, free and clear. Basically, it is the current market value of your home, minus what you still owe on the mortgage loan you used to purchase it. You build equity in your home as you make payments on that mortgage, your equity increasing as the balance remaining on your loan decreases. Increases in the market value of your home over time also help build your home equity.
Home equity is often referred to as “forced savings”, since accumulated equity is accumulated wealth, but that wealth is not readily accessible. You can, of course, access that savings by selling your home, but home equity loans offer a means of cashing in on your home equity without taking that step.
How Home Equity Loans Work
Home equity loans are mortgage loans, commonly called second mortgages, in which a homeowner’s equity in a home is used as collateral. That means that they are secured loans, much like traditional mortgages, and as with those traditional mortgages, your home is on the line should you fail to repay the loan amount as agreed. There are two basic types of home equity loans that are common today, traditional, lump-sum home equity loans and home equity lines of credit.
Traditional Home Equity Loans
These home equity loans allow you to borrow a set amount against your home equity, which is provided to you as a lump sum. You then would pay that loan back – with interest, of course – via a fixed monthly payment. These types of loans are most often given for shorter terms than a typical first mortgage, generally ranging from 5 to 15 years.
The amount you can borrow will depend on several factors, including your credit history, your income, the market value of your home and the amount of home equity you have accumulated. Most lenders will limit the amount you can borrow to no more than 80 to 85 percent of your home’s value. If you still owe on an existing mortgage, that outstanding amount will be factored into your borrowing limit, reducing the total amount you can borrow via the home equity loan.
Home Equity Lines of Credit (HELOC’s)
These home equity loans work a little differently, providing a revolving credit account, rather like a credit card. Borrowers are preapproved to borrow a certain amount against their home equity. That preapproved amount is rather like a credit limit on your credit card. You can use as little or as much of that amount as you need to, so long as you do not go over your limit.
Like traditional home equity loans, HELOC loans are given for a fixed term. Typically, there is a draw period, during which you can make interest-only payments, then an additional repayment period during which you will be responsible for paying off the principle (the amount you borrowed) along with the interest. Interest rates are variable with most HELOC loans, which means they may fluctuate according to market conditions during the life of your loan.
Home Equity Loans: The Pros and Cons
The pros of home equity loans include the ability to leverage your home equity for needed cash for uses like making home improvements, paying for college or consolidating debts. They generally come with lower interest rates than unsecured loans, like credit cards or personal loans, and can be easier to qualify for with less than stellar credit, since these loans are secured with your home. If the loan is used to make substantial improvements to your home, you may be able to deduct a portion of the interest from your taxes.
Potential drawbacks of home equity loans include the closing costs and other fees that can be involved with securing these loans, which can cost thousands of dollars. The fees and costs vary between lenders, so shopping around can help minimize these costs. Then, there is the fact that the loan is secured with your home as collateral. This means that if you run into financial trouble during the term of your loan and fail to make payments as promised, your home equity lender can foreclose on your home, taking possession of your property and selling it to recover the loan amount. Additionally, should you decide to sell your home before the end of the loan term, the amount you still owe on your home equity loan must be paid in full when the home is sold.