A home equity loan is also called a second mortgage. It allows the homeowner to borrow against home equity (which is the difference between the property value and the balance of the mortgage against it). The home equity loan delivers a lump sum at closing and is repaid in monthly installments. Most home equity loans have fixed rates, but some are adjustable.
How much can I borrow?
Home equity lenders typically loan against 80 to 90 percent of the property value. For example, a homeowner with a $100,000 house and a $50,000 mortgage balance has $50,000 in home equity. If a lender is willing to loan against 80 percent of the property value, the homeowner could get a $30,000 home equity loan. That’s the $100,000 property value times 80 percent, which is $80,000. Subtract the $50,000 balance of the existing mortgage from $80,000 and the result is $30,000.
How They Work
Home equity loans are often called second mortgages because their lenders are in what’s called second position. These lenders are also referred to as junior lienholders. This means that if the homeowner did not make the payments of either the first mortgage or the home equity loan, either lender could foreclose, take the house and sell it at auction. However, the lender in first position is repaid first. The junior lienholder is only repaid in full if there is enough money from the foreclosure auction to repay both balances. For this reason, second mortgages have higher interest rates than first mortgages – their lenders are in a riskier position.
Who Should Get One
Home equity loans are best suited for situations in which the borrower knows how much money will be needed and when it will be needed. Because the borrower receives a lump sum of money, he or she will be paying interest on the entire loan amount – so it’s best for homeowners to know how much will be needed before borrowing. Home equity loans work well for debt consolidation, home improvements that require a large payment to a builder, or big-ticket purchases like a vacation cabin.
Home equity loan advantages include the availability of a fixed interest rate, which makes budgeting easier, and the fact that they cannot be shut off or closed like a HELOC.