How Does a Home Equity Loan Work?

Home equity loans make it possible to borrow against the value or your home or property. If your home has increased in value tremendously – or, if you've paid down a significant portion of your mortgage – a home equity loan lets you tap into your stored wealth.

While many consumers use home equity loans for remodeling projects and home-related upgrades, it's important to note that you can use your home equity loan for anything you want.

Home equity loans function as a second mortgage on your home. You don't have to alter your existing home mortgage to qualify for a home equity loan, and you may be able to borrow up to 90 percent of your home's value altogether.

How Home Equity Loans Work

With a home equity loan, you'll receive a large sum of cash and an accompanying repayment schedule. Typically, you'll make a monthly payment on your home equity loan just as you would on your regular mortgage.

To qualify for a home equity loan, you'll apply with a traditional or online lender. Just like you would with a traditional mortgage, you'll need to gather bank statements, pay stubs, and employment information for your application. The home equity lender will require an appraisal on your property for you to qualify. The amount of equity you have – along with your income and credit score – will determine the amount of money you can borrow against your home.

While homeowners were once able to borrow up to 100 percent of their home's value, new restrictions have limited the amount of equity you can withdraw. Currently, the amount you can borrow is usually limited to 80 to 90 percent of your home's value across your traditional mortgage and any other loans.

If your home is worth $200,000, for example, the amount of your first mortgage and home equity loan combined shouldn't be more than $160,000 - $180,000 depending on your lender's requirements.

Benefits of Home Equity Loans

The biggest benefit of home equity loans is just how flexible and hassle-free they are. Applying for a home equity loan doesn't require you to tamper with your first mortgage, and you can use the money how you see fit.

Here are a few other important benefits to consider before you apply for a home equity loan:

  • Low interest rates: Depending on your credit score, you could qualify for a home equity loan with a shockingly low interest rate. As you explore your options, make sure to shop around with a few different lenders for the best deal.
  • Tax benefits: You can deduct the interest from the loan just as you would with interest from your mortgage. If you itemize when you file taxes, this benefit can help you save money.
  • Easy qualification: Since a home equity loan is secured by the equity you have in your home, you may be able to qualify with less-than-perfect credit.
  • Use the money how you want: Where your first mortgage was used to buy your home, the funds from the loan can be used however you wish.

Home Equity Loans: What to Watch Out For

Borrowing money against your home's value may seem ideal, but as always, there are pitfalls to watch out for. The first and most important "gotcha" to consider is the fact that your lender can seize your home if you don't repay your loan.

Second, a lot of consumers find home equity loans far too tempting. If you ever want to own your home outright, you should strive to only borrow against your home's value when necessary. If you take out a loan against your home’s equity more than once – or open a home equity line of credit you continually borrow against – you may struggle to rebuild equity in your home and end up paying your home's value in mortgage payments many times over.

Lastly, it's crucial to make sure you're dealing with a reputable company when borrowing against your home's value. With any financial transaction, there's the potential to fall victim to a scam. Make sure you're dealing with a lender with good reviews and a positive score with the Better Business Bureau (BBB).

How Does a Home Equity Loan Work in Relation to Cost?

The costs of any home equity loan depend on the size of the loan. Other factors that will influence your loan's total costs include:

  • Your interest rate, or APR
  • Closing costs
  • Prepayment penalties, if applicable
  • Repayment timeline

A home equity loan calculator can help you determine how much you may be able to borrow. From there, you can figure out a general range for the costs of your loan.

Example: Let's say your home is worth $200,000 and you owe $120,000 on your first mortgage. If your lender caps the amount you can borrow at 90%, you could potentially qualify for a home equity loan worth $60,000.

Closing costs on a home equity loan typically add up to 2-5% of the loan. For a $60,000 loan, that means you would pay $1,200 to $3,000 in fees. These fees are used to cover attorney and title company fees, a title search, document preparation, application fees, and appraisal fees. Some home equity loans also charge a maintenance fee.

You'll also pay a total sum of interest throughout the life of your loan. This amount depends on your interest rate, or APR. On a ten-year, $60,000 loan at 4% APR, you would pay approximately $610 per month and $12,896 in interest through the end of your loan's term.

Best Ways to Use a Home Equity Loan

Whatever your financial needs are, a home equity loan can help you extract cash from your home's growing value. Popular uses for home equity loans include:

  • Paying for college. Home equity loans are popular for parents who want to help their children with college costs. They can tap into the equity of their homes, secure a fair interest rate, and score a tax deduction in the process.
  • Remodeling your kitchen or bathroom. Home equity loans are perfect for families who need a cash infusion to remodel their homes. As a bonus, a good remodeling project can increase your home's value.
  • Consolidating high interest credit card debt. If you're carrying a lot of high interest credit card debt, a home equity loan can help you consolidate your debts at a lower interest rate.

How Does a Home Equity Loan Work in Comparison to a Home Equity Line of Credit (HELOC)?

As you explore your loan options, it's crucial to understand one final distinction. A home equity loan is similar to a home equity line of credit (HELOC), but they are not exactly the same.

Where a home equity loan provides you with a lump-sum of cash, a HELOC provides a line of credit you can borrow against.

A HELOC comes with certain advantages because it allows you to borrow only what you need, but also borrow several times as you need more cash. This option lets you make smaller payments for several years until your loan requires you to make fully amortizing payments so you can pay it off in its entirety. And if you wind up borrowing less money, you'll save money on interest payments in the process.

The downside with HELOCs is that their interest rates are normally variable, meaning your interest costs could change over the years. Still, it's worth considering a HELOC if you aren't sure how much you need to borrow from a loan. With a home equity line of credit, you can create the loan you want and borrow exactly what you need.

Both home equity loans and HELOCs are solid options if you want to access the equity in your property. The best option for you will depend on your specific needs and the type of loan you feel comfortable with.

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