What is a home equity loan? How does a home equity loan work?
To many people, the benefits of homeownership are clear and compelling from day one. Your home's equity is one benefit you might not think about for a few years, though. Much like your initial mortgage is a loan based on the appraised value of your home, a home equity loan is a loan based on the amount of equity you've gained in the property.
When you begin making monthly payments on your mortgage or even submit a down payment, you are establishing equity in your house. And this equity can be tapped into in the form of a home equity loan or as part of a refinance. As with any home loan, you’ll want to check current mortgage rates to make sure you’re getting the best deal.
In this article, we’ll talk about home equity loans, how much you can borrow, how to go about it, and examine some of the pros and cons associated with home equity loans.
What is home equity?
Some point to the pride and prestige of owning their own home or the feeling of gratitude that comes with being part of a community. Others are drawn to notions of privacy, freedom or building wealth that can one day be transferred to a loved one. No matter the reasons cited, the rewards of homeownership are rich and diverse. Equity is a more tangible benefit of being a homeowner.
To understand home equity, you need to understand home value. They are intimately related.
If your home is valued at $400,000, then your home equity will always be an amount lower than that. Home equity is the difference between the value of your home and the existing amount you still owe on your mortgage. Every mortgage payment you make adds to your home equity. The more payments you make on your principal over the lifetime of your loan, the more equity you build.
If you’ve repaid $100,000 on that original $300,000 mortgage then you still owe $200,000. If you subtract that figure from the original price you are left with $100,000. That’s your current home equity. This is what you’ve put into your home thus far.
What is a home equity loan?
A home equity loan is when you use your home as collateral to access cash in the form of a lump-sum payment. In effect, you are borrowing against your built-up equity at a fixed rate determined by current interest rates.
As outlined above, when you pay down your loan your equity goes up. Obtaining a new home appraisal that results in increased value for your home is another way to increase home equity. There can be many macro and micro economic reasons that your home value increases. There are also times when home value decreases or remains relatively stagnant.
Because tapping home equity can significantly affect home financing, you will need to satisfy certain conditions and be approved for the loan, much like you were approved for your original mortgage. In fact, it can be useful to think of a home equity loan as less of a loan and more of a second mortgage. You will need to pay back the principal (the loan itself) as well as the interest outlined by your lender in a term usually between 5 and 30 years. Rates will vary, and it’s always important to compare offers from different lenders.
How does a home equity loan work?
We’ve discussed how to compute home equity, but determining the maximum amount available for you to borrow requires a small formula. Let’s take a look:
First equation
Current home value x Percentage of home value you’re allowed to borrow =
Maximum amount of borrowable equity
Second equation
Maximum amount of borrowable equity − Remaining mortgage balance =
Maximum amount you can borrow off of your home equity
Percentage of home value you’re allowed to borrow
While interest rates may fluctuate from lender to lender, the percentage of home equity that your lender will allow you to borrow is usually between 80- 85% of your home equity.
Additionally, because you’re using your current home as collateral for the loan, the lender’s risk increases. If approved, you’ll have two loans to pay off: your initial mortgage and now the home equity loan, which is your second mortgage. To offset that risk (while still offering you a cash loan), lenders impose some limits on the size of the loan while setting mortgage rates at a level above what they would charge for a first mortgage (more on this below).
Home equity loan example
Let’s assume your current home value is $400,000 and your remaining balance on the loan is 200,000. This computes to a 50% LTV (loan to value ratio), which is considered a good percentage by most lenders for home equity loan purposes.
Your lender allows you to borrow up to 80% of your home’s value, the maximum amount of borrowable equity would be $320,000 (.80 x 400,000 = 320,000).
Following our formula, we take that number and subtract the remaining balance on the mortgage, which is $200,000 (assuming $200,000 has been paid back already). $320,000 - $200,000 = $120,000.
$120,000 is the total amount you can borrow from home equity.*
Home equity loan rates
When considering a home equity loan, one of the first things you’ll notice is that the rates are typically higher than they are for a home purchase or even a standard rate and term refinance. The reason? The lender is put into a second-lien position behind the initial mortgage and this has consequences.
In the event of a loan default and subsequent foreclosure that results in the sale of the house, the home equity loan lender is second in line to get paid behind the lender of the first mortgage. This produces greater risk in recouping the borrowed funds. Given this increase in risk, home equity loan interest rates are often slightly higher.
Home equity loans: pros and cons
Depending on your financial situation, a home equity loan can be a great way to access funds. But like any loan, it has an upside and a downside, pros and cons. Let’s take a look.
The pros of obtaining a home equity loan
- Provides borrowers with a loan at a fixed interest rate.
- Depending on the economic environment in which you borrow, you may be able to lock-in low interest rates over the lifetime of the loan.
- The loan is dispersed as a lump sum of money to spend as you wish. If you’re using the money to consolidate debts or make a significant purchase, this can be of great benefit.
- Consistent payments every month for a predetermined amount of time.
- Money is tax deductible if used for home improvements.**
The cons of obtaining a home equity loan
- As a second mortgage, the loan could put strain on your personal finances.
- Your home is used as collateral, which sets you up for foreclosure should you be unable to make payments on the loan in the future.
- Closing costs must be paid as part of the loan transaction. Expect anywhere between 2%-5% of the loan amount.
- By accessing cash funds, you’re reducing existing equity.
- You may face issues with selling your home while you have an outstanding home equity loan. This is something you’ll want to discuss with your lender before proceeding.
- Could affect your PMI (private mortgage insurance) premiums. Due to the fact that tapping into your home equity will increase your LTV ratio, the lender may raise premiums to cover any resultant increase in risk.
Home loan qualifications
Each lender has slightly different qualifications when it comes to home equity loan, but generally speaking, if you meet the following requirements you're a good candidate for approval:
- Existing home equity in a range of 15-20%
- A credit score 620 or greater
- Debt-to-income ratio below 43%
- Conduct an appraisal to determine fair market value of your home
Having bad credit is not necessarily an impediment to securing a loan, but it’s much safer to be in the “good” or even “fair” credit score range when applying for a home equity loan.
Home equity loan vs. HELOC
Understandably, there exists some confusion between a traditional home equity loan and what’s called a HELOC, or home equity line of credit. They may sound similar but they are not the same.
First of all, both loans are secured by a borrower’s home equity and require an approval process in which credit scores are prominently featured. As stated above, a home equity loan provides the homeowners with a lump sum, which they in turn must repay at a fixed rate over an agreed amount of time.
A HELOC on the other hand is a revolving credit line extended to borrowers up to a certain preset credit limit. Payments are not typically fixed and borrowers will be subject to variable interest rates—much like credit cards.
Additionally, a HELOC only enables you to take out loans on a periodic basis; you don’t receive the entirety of the loan—the line of credit—all at once. Borrowers tap into their line of credit as needed, begin repayment, and then return to the line of credit if/when they need access to additional funds. There is a draw period when you can borrow money and are typically obliged to pay some interest-only payments on the loan, and a repayment period where you must pay back the principal plus interest. Borrowers need to be careful to budget for any increases in interest rates that can affect repayment amounts.
The Home equity loan vs. cash-out refinance
While home equity loans are widely considered a great way to tap into existing equity to secure cash funds for a variety of reasons, a cash-out refinance is another popular method that leverages home equity to make cash available.
Both home equity loans and cash-out refinances rely on using your home collateral to obtain a loan (this also true for a HELOC). Both also require an approval process. There are many similarities between these two types of loans, but the key differences is that a home equity loan is in essence a second mortgage—it’s an entirely new loan that you must pay off in addition to your existing home mortgage. A cash-out refinance loan is exactly that—a refinance loan that replaces your original loan with one that has new interest rates and potentially new terms.
Additional differences between home equity loans and cash-out refis
Home equity loan interest rates are typically fixed, while a cash-out refi can feature a fixed or variable APR. There are closing costs involved for both loans, although since a cash-out refi is essentially a new mortgage, the closing costs are higher than what they would be for a home equity loan. Terms can vary from 15 to 30 years for a cash-out refinance while a home equity loan is typically paid back between 5 and 30 years. Home equity loans tend to have higher interest rates since they are second mortgages, and if you fall behind in payments the initial mortgage gets prioritized.
The good news: For either loan, if the cash taken out is used to improve the home, the loan is tax deductible.**
In conclusion
For individuals in need of cash for important home improvements or other significant purchases, a home equity loan is often a go-to option. Homeowners can tap existing equity in order to get a loan with favorable terms and affordable home equity loan interest rates.
While it can be a mighty responsibility to take on what is essentially a second mortgage, for those who can manage the additional monthly payments, the rewards are frequently worth it. Take a moment today to talk to a trusted lender and find out more about home equity loans and other loan and financing options.
*Sample scenario provided for illustration purposes only and is not intended to provide mortgage or other financial advice specific to the circumstances of any individual and should not be relied upon in that regard.
**Rate does not provide tax advice. Contact your tax advisor with any tax related questions.
