A Simple Explanation of How a Home Equity Loan Works

So, you live in a house you love. You're obsessed with the backyard, but you wish the bathroom was a little nicer. You can comfortably make your mortgage payment, but you wish your credit card debt wasn't so high. These are common financial issues that arise among Americans, and many people who want to pay down debt or improve their home tap into their home's equity in order to do so.

You might be wondering what it means to have home equity or if it's even something available to you. This is a great question because not every homeowner will have home equity. It really depends on the purchase price of your home, what the market has done since you bought your home, how much money you put down as a down payment, and how much of your mortgage you've paid off so far.

Home equity by definition is the current value of your home minus what you owe on your home. So, let's say you're a fabulous young family who recently bought their first home in an adorable neighborhood that is becoming more and more popular as time goes on. Even though you didn't put down a large down payment and you owe $150,000 on your home, your home's value skyrocketed over the years because it's in such an awesome location. If your home is now worth $200,000, that means that you can potently take out a home equity loan for a percentage of that equity and use it to complete upgrades inside your home or pay off other debts you may have.

Things to Keep in Mind

It's important to note that a home equity loan is often called a "second mortgage" because you're essentially taking out another loan against your home. Although a home equity loan can be a fantastic tool to get your finances in order by allowing you to tap into some of your home's value, it will make it so you owe more money on your home. This should be a concern for people who want to sell their homes soon, because if you borrow to the max of what your home is worth, you might have to sell it at a loss if a buyer negotiates down on your price. However, if you're going to be living in your house for quite some time, then this could be a good way to utilize the value of your home to make improvements to make it even more valuable and more enjoyable to live in long term.

Home Equity Loan vs. HELOC

Two terms that are sometimes use interchangeably are home equity loans and a home equity line of credit (more commonly known as a HELOC). Although these two terms seem similar, they are not the same thing. With a home equity loan, you're going to get a nice chunk of change all at once, sort of like if you were to get a personal loan from a bank. A HELOC is more like a credit card. It's a line of credit that you can tap into from time to time when you need it. So, just note that if you do go the home equity loan route, it's going to be a sum of money that you get at once, so you should have a nice, organized plan for what you want to do with it.

How to Get a Home Equity Loan

If you're reading this and are thinking to yourself that you could benefit from a home equity loan, here's how to get one. First, you should have a plan for the funds. According to the U.S. Census, 45% of people who use home equity loans use them to make improvements on their current properties. Then, you should know the value of your home, whether you determine this from your purchase price or a new, formal appraisal. Once you have this information, shop around for a lender. You don't have to use the same lender who gave you your mortgage. Instead, apply to a few different lenders so you can ensure you get the best rate. You can also ensure you get the best rate by having excellent credit. If all goes well, you should be able to take out a home equity loan and use it to make improvements on your home or pursue other financial goals. Just remember that a home equity loan is still a loan. It will increase your overall debt and add a monthly payment to your budget spreadsheet, so weigh your options carefully and only pursue this route if you feel like it will add considerable value to your home and improve your overall financial life in the long run.

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