Home equity loans aren't difficult to understand, but homeowners should make sure they know what home equity is, how to calculate home equity, and how home equity credit works before they apply for this type of loan.
What Is home equity?
Home equity refers to a homeowner's ownership interest in his or her home, often stated as a percentage of the home's value or a dollar amount.
How Is home equity calculated?
To calculate home equity, start with the home's current value and then subtract the total outstanding balance of all loans secured by the home. Home equity is calculated using the estimated current market value, not the price the homeowner paid to buy the home, and the current loan balances, not the original amounts borrowed.
- Market value: $100,000
- Mortgage balance: $80,000
- Home equity: $100,000 - $80,000 = $20,000
- Home equity: $20,000 / $100,000 = 20 percent
- Market value: $200,000
- First mortgage: $60,000
- Second mortgage: $20,000
- Home equity: $200,000 - ($60,000 + $20,000) = $120,000
- Home equity: $120,000 / $200,000 = 60 percent
- Market value: $450,000
- Mortgage balance: 0
- Home equity: $450,000
- Home equity: $450,000 / $450,000 = 100 percent
What Is Home Equity Credit?
Home equity credit is an account secured by a homeowner's equity. Many homeowners who have an equity loan also have a first mortgage, though it's possible to get an equity loan if there is no first mortgage.
The home equity calculation is important because home equity lenders typically allow homeowners to borrow against only a certain percentage of their equity -- often 80 to 90 percent of the home's value.
A homeowner with a lot of equity would be able to borrow more than a homeowner with little equity. A homeowner with no equity would not be able to get a home equity loan.
Home equity loans can be used for any purpose, such as buying a car, taking a vacation, consolidating credit card debt, or paying for college tuition. The most popular use, according to the US Commerce Department, is to make home repairs or improvements.
How Does Home Equity Credit Work?
There are two types of home equity loans: installment loans, which are often called "second mortgages," and home equity lines of credit, or HELOCs.
A second mortgage gets the borrower a lump sum that's scheduled to be repaid over a specific time period. Interest rates are usually (but not always) fixed. Payments may be fixed or variable, depending on the rate and structure of the loan.
A HELOC is a revolving line of credit that may be drawn on up to its preset limit. It's flexible -- the money may be borrowed in whole or part over time, repaid and borrowed again. HELOCs typically have a variable interest rate and may involve a future balloon payment.
It can be helpful to think of a second mortgage as being like a car loan and a HELOC as being like a credit card. However, there's an important difference: home equity credit is secured, or backed, by the homeowner's equity. If that loan isn't repaid, the lender could foreclose and the homeowner would lose the property.
Fees and repayment terms for home equity credit loans and HELOCs vary, so it's smart to shop around, compare loan quotes and discuss the details with a reputable lender.