Home Equity Loans and Lines of Credit

What is a home equity loan? It's simply a form of borrowing in which the loan is secured by residential property. That means a home equity loan is also a mortgage. In fact, home equity loans are often referred to as "second mortgages."

How Do They Work?

Homeowners build equity by paying down their mortgages over time, and they also add equity when their properties increase in value. Home equity loans allow homeowners to exchange some of this home equity for cash. To qualify, most experts say borrowers should have at least 20 percent home equity -- today, few if any home equity lenders lend against 100 percent of the property value.

How to Calculate Home Equity

Here's how to calculate equity: simply subtract the total of all mortgages against the home from its fair market value. The difference equals the dollar amount of home equity. So a property valued at $100,000 with an $80,000 mortgage balance has $20,000 of equity. Home equity can also be calculated as a percentage of the property value. In that case, divide the dollar amount of home equity by the home's fair market value. In this example dividing the $20,000 of home equity by the $100,000 property value equals .2 or 20 percent.

Many lenders will approve a home equity loan up to 90 percent of the property value. In this example, then, the homeowner could probably borrow $10,000.

Loan or HELOC?

Home equity financing comes in two forms -- the traditional loan delivers a lump sum and is paid down in monthly installments, and the HELOC, or home equity line of credit, is a revolving account that can be used and reused, much like a credit card. Home equity loans usually come with fixed rates, while HELOCs almost always carry variable rates.

Borrowers should select their product according to its planned use. Loans with fixed rates and predictable payments are best when homeowners want a lump sum for debt consolidation, investment property or other big-ticket purchases. HELOCs are ideal when flexibility is needed -- for example, to start a business, pay college tuition every semester, in case of emergency or to fund ongoing home improvements over time. The advantage of HELOCs is that interest only accrues for the amounts used.

Home Equity Loan Costs and Interest Rates

Home equity loans are processed much more quickly than home purchase loans. Fees for home equity loans are typically no more than a few hundred dollars, and lines of credit may have no fees at all.

Interest rates for home equity loans are higher than those of first mortgages. That's because any mortgage that homeowners already have against their property takes precedence over later loans in the event of a foreclosure. If the foreclosure sales doesn't bring in enough to repay both loans, the home equity lender loses money.

Because of the added risk of being what's called a "junior" lienholder, home equity lenders charge higher rates than lenders in first position, whether they are financing the property purchase or a refinance.

Other Considerations

There are a few other home equity considerations:

  • Home equity lines of credit can be cut or canceled if the home value drops. Those who want to be certain of having access to all of their equity may prefer the home equity loan over the HELOC.
  • Some home equity loans with variable rates can be converted to fixed-rate loans at one or more times during their terms.
  • Home equity lines generally have two phases -- the drawing phase and the repayment phase in which the line can no longer be tapped and regular monthly payments are required.
  • Home equity loans may be amortized over 30 years, which keeps the payment lower, but the actual term might be shorter -- ten or 15 years. This means borrowers must make a balloon payment or refinance the remaining balance.

Home equity financing, because it's secured by property, is some of the cheapest available. However, it does carry the risk of foreclosure if the homeowner defaults, and that risk should be carefully considered.