How Does a Home Equity Loan Work?

Should the time come when you're in need of a significant amount of cash, if you are a homeowner, you have some options beyond going the personal loan route. One of them is a home equity loan.

A home equity loan is borrowing money using your home equity as the basis of how much money you will receive, explains Kyle Winkfield, managing partner of O'Dell, Winkfield, Roseman & Shipp, a wealth management and retirement planning firm in Rockville, MD. In essence, your home is the collateral, and the pay back works similar to a mortgage. Here's how it breaks down:

What Equity Means

"Equity is how much of the home you own at a point in time," says Winkfiled. For instance, if your home is worth $500,000 today, and you owe $400,000 on your mortgage, you have 20 percent equity. What's tricky is that equity does change, as people learned the hard way during the real estate downturn in 2009, when home values plummeted. Equity can also increase as home prices rise, or if you've made significant home improvements.

Depending on the lender, you may have to have your home appraised to determine its current value. Some banks rely on home sales in the area (called comparables) or do what's called a "drive by" appraisal, says Winkfield, while other situations might call for a full-fledged walk-through. The latter will have an additional cost to you, usually a few hundred bucks that can likely be rolled into the loan.

For loan purposes, the more equity you have, the better shape you're in to borrow against your home (and you'll probably have more funding available to you). Lenders each have their own loan-to-value ratio threshold, whereby some will not extend you a loan if you have less than 20 percent equity, for instance. Others might lend even if you're closer to the 10 or 5 percent mark. Winkfield points out that once you cross into territory in which you have less than 20 percent, you may be required to pay private mortgage insurance, which will add to your monthly expenses.

The Appeal of a Home Equity Loan

What's appealing about a home equity loan to most borrowers is that you can often qualify for a very low interest rate, which will be fixed over the life of the loan – that's especially true in today's historically low rate environment. In other words, you'll pay back the same amount each month, and not as much as you would with higher-interest products, says Winkfield.

One drawback is that this loan type usually has closing costs and fees, which will be tacked onto the total amount borrowed, so don't forget to factor that in.

However, on the plus side, the interest you pay back on a home equity loan is usually tax deductible. Unlike personal loan or credit card debt payoff, you can get a tax benefit from home-based debt, says Winkfield.

How to Qualify For An Equity Loan

Just because the loan is based on your home value doesn't mean there are no other qualifications. "Your house is only a measuring stick for how much money you can get. Any time you're going to request money from the bank, they care about your history of paying back debt (that's your credit score) and your ability to pay them back (that's your income)," says Winkfield.

In other words, just like when you applied for your home mortgage or auto loan, the bank will run a credit check and ask for pay stubs or other proof of income as part of the approval process. Those with stellar credit will qualify for a better interest rate than those with mediocre FICO scores.

Don't Confuse It with a Home Equity Line of Credit

People often get these products confused, says Winkfield, but they are not the same other than the fact that they are based on your equity. With the line of credit, it essentially works the same as a credit card – the money is there to borrow if you need it, and the interest rate can change over time. With a loan, you get the money up front and pay it back at a fixed rate.

As with any borrowing decision, experts recommend looking at the big picture and thinking long-term about your finances. Making sure you have a plan in place to pay back the loan is key, says Winkfield. "Remember that a home equity loan is a tool. Make sure you're using it to build you up and not break you down."

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