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How Does A Home Equity Loan Work?

how does a home equity loan work

After years of dutifully paying your mortgage, you would have built substantial equity in your property by now. If you’re ready to use some of that value, a home equity loan could be a great option.

Home equity loans allow homeowners to draw on the equity, providing access to cash that can be used for anything from paying down other debt to improving the home — or simply making lifestyle purchases.

What is a home equity loan?

Basically, home equity is the difference between the overall worth of your home minus how much you owe on the principal balance. You create equity in your home by paying off your home loan, making improvements and, ideally, holding on to it as the value increases.

A home equity loan — sometimes called a second mortgage or a home equity installment loan — allows a property owner to borrow against that equity value.

Home equity loans can have many uses, including a remodeling project, to pay down other debts or even to buy a car instead of taking out a traditional auto loan. Depending on what you use the money for, interest paid on a home equity loan might be tax-deductible.

How does a home equity loan work?

Home equity loans give borrowers a lump-sum cash payment that’s paid back over time. Much like a first mortgage, a home equity loan typically comes with a fixed rate and a steady repayment schedule, allowing borrowers to fix their costs. Borrowers make a principal and interest payment each month.

How much you’re able to borrow is tied to the loan-to-value ratio on your home. This is calculated by dividing the total amount outstanding on all of your mortgages by the property’s value. Typically, lenders prefer the overall loan-to-value ratio to be a maximum of 90% after the new home equity loan is factored in, said Utah-based mortgage broker Jason Skinrood.

Here’s an example: If a couple owns a home worth $200,000 and has $100,000 remaining on their mortgage, they have $100,000 in home equity. If they wanted to obtain a home equity loan for a lump sum of $50,000, they would have a 75% loan-to-value ratio, which is a favorable amount, Skinrood said.

If you want to see how much home equity you’ve built up in your home, you can check out LendingTree’s home equity calculator.

Home equity loan vs. home equity line of credit

Home equity loans differ from another popular lending product with a similar name, a home equity line of credit, or HELOC.

With a home equity loan, a borrower gets a lump-sum payment and is subject to terms that are similar to a first mortgage.

A HELOC functions more like a credit card. Homeowners apply for access to a credit line based on the equity in their property, but they only draw on the money as they need it. Much like a credit card, the amount taken out is subject to repayment terms and interest rates. Interest rates on a home equity line of credit are usually variable and can change over the period of the credit line. Typically, HELOCs come with an interest-only period, often 10 to 15 years, and then the borrower needs to begin repaying the principal.

HELOCs are a popular product for homeowners who want a safety net and access to cash when they need it, said Jennifer Beeston, vice president of mortgage lending at Santa Rosa, Calif.-based Guaranteed Rate Mortgage. “If you want to take out $50,000 because you’re remodeling your kitchen, you can do that and still have access to the rest of the credit line,” she said.

One drawback of a HELOC, mortgage advisors note, is that the line of credit is only available for a determined period of time before expiring. Also, monthly payments can spike when the interest-only period expires, potentially jumping from just a few hundred dollars a month to double or triple that amount.

“A HELOC is more flexible but comes with some more unpredictability,” Skinrood said. He added a home equity loan is better-suited for borrowers who want predictable, consistent loan terms.

Interest rates on home equity loans

Home equity loans typically have interest rates slightly higher than the current rates for primary mortgages. That’s because they are perceived as a higher risk to lenders. In the event of a default or foreclosure, the home equity lender would be the second entity to pay back.

The interest rate offer you get on a home equity loan is usually based on the following factors:

  • Current mortgage balance
  • Property value
  • Loan term
  • Loan amount
  • Credit history
  • Income

As interest rates creep up, rates for home equity loans are rising as well. At the time this was written, the rates advertised through the LendingTree platform ranged from 4.25% to 6%, depending on how much is borrowed.

Terms

Home equity loans operate with similar terms as a primary mortgage. This typically includes a fixed term of 10, 15, 20 or 30 years, a fixed interest rate and a regular monthly payment.  

Like a first mortgage, when you pay back your home equity loan each month, you’re paying down principal and interest. If you fail to make payments on time, that could possibly trigger foreclosure proceedings by your lender.

Fees

Traditional home equity loans typically have only small costs associated with them. Many lenders do not require an application fee or closing costs. If you need to get an updated appraisal on your home, that could be an out-of-pocket expense.

Under new federal tax rules, taxpayers may be able to deduct interest on a home equity loan, according to the Internal Revenue Service. This depends on how the money is used. Home equity loans used for home additions or improvements typically qualify. But using the money to pay off other debt, such as credit cards or to student loans, would not be deductible, the IRS said.

Credit requirements

While a low credit score and previous bankruptcies will affect the home equity loan offers you receive, they don’t necessarily disqualify you. It is up to the lender to determine if you’re a good candidate for a second mortgage — and if you’ve built up considerable equity in your home and made regular payments on your first mortgage, that helps your chances.

However, if you’ve declared bankruptcy in the past, it can take up to six or seven years to qualify for a home equity loan.

Qualifications for a Home equity loan
Loan-to-value ratio Your LTV ratio should not exceed 90% of the appraised value of the home.
Credit score Higher credit scores can expect more favorable terms. Applicants with a low credit score or bankruptcy history may have to wait longer or shop around with several lenders.
Length of loan Typically 10, 15, 20 or 30 years
Fixed or adjustable rates Fixed
How long it takes to get funds Once approved, a lump-sum payment is usually available in a few weeks.

Where to get a home equity loan

To find a home equity loan, you can check out LendingTree’s home equity comparison tool to find the best options to fit your needs. Homeowners should shop around for the best rates and terms. Check in with your primary mortgage lender, as well as local banks and credit unions.  

When shopping for a home equity loan, Beeston suggests homeowners ask the following questions:

  • What is the interest rate?
  • Is this an introductory rate? If so, how long is it good for? What is the rate after the introductory period?
  • Is there an interest-only period? If so, how long is the interest-only period?
  • What is the repayment period?
  • Is there an annual fee?

The bottom line

If you have diligently paid off a home loan and cared for your property, a home equity loan can allow you to unlock the value you’ve built in that asset. If you are attracted to the predictability of a home equity loan’s fixed interest rate and monthly payment schedule, this could be a good fit.

 

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