Home equity and home equity loans are terms used often, but what do they mean? Home equity loans and home equity line of credit (HELOCs) allow homeowners to convert some of their home equity to cash, which can be used for almost any purpose.
Home equity loans are often referred to as "second mortgages," because most borrowers also have a traditional mortgage. In the event of a foreclosure sale, the traditional (first) lender is repaid first, and then the home equity (second) lender is reimbursed if there is enough money to do so. This makes home equity financing riskier for lenders, and so it comes with a higher interest rate.
Home equity loans can be used for many purposes, but it's important to consider a home equity loan in terms of individual financial needs and goals. Here's an explanation of home equity and how homeowners can estimate how much equity they have.
How to Calculate Home Equity
Home equity is the difference between the property's value and the loans against it. For example:
- Home value: $400,000
- Mortgage balance: $225,000
- Difference: $175,000
The $175,000 difference is the amount of home equity the borrower has. A residential appraisal is typically required to establish a home's current value for lending purposes.
How (and When) to Use Home Equity Loans
Researching home equity loan options before contacting lenders can help prevent problems later. The FDIC recommends checking and comparing loan features including:
- Interest rate and monthly payment
- Lender fees and discount points (one discount point is equal to one percent of the loan amount.)
- Loan term
- Late fees and pre-payment penalties
A home equity loan can be used to meet specific financial needs and goals:
- Debt consolidation: Homeowners who carry credit card debt, personal loans and vehicle loans can roll multiple debts into one with a home equity loan. This simplifies bill paying and can help with avoiding late fees and interest rate increases caused by overlooked payments. To make sense, the home equity loan should have a lower interest rate than those of the debts it replaces. Home equity interest is often tax deductible, increasing its appeal (check with a tax pro). Homeowners need to understand, however, that while debt consolidation can lower their interest costs and / or monthly payments, the total amount of debt has not changed -- they still owe the money!
- Home repairs and renovation: Drawing against home equity to pay for upgrades, repairs and remodeling can help homeowners increase their property value while making their homes more comfortable and functional. Home equity loans, which deliver a lump sum at closing and usually have fixed rates and payments, can be the best way to pay for a big renovation like a home addition. HELOCs, which allow borrowers to withdraw money as needed, can be better for longer projects involving a series of smaller expenses. With a HELOC, borrowers pay interest only on amounts they've withdrawn.
- Big-Ticket Purchases: Home equity financing can provide funds for vehicles, educational expenses or a small business. Homeowners considering home equity loans for these purposes need to compare home equity loan options with other financing sources such as federal and private education loans, loans offered by vehicle dealerships and Small Business Administration (SBA) loans.
The FTC encourages homeowners to compare quotes from lenders carefully before choosing. It's easy to obtain and compare online quotes from competing lenders here at LendingTree.com.