Home equity refers to the amount of money you've paid off on your home through your mortgage or home loan. You can get the amount of your home equity by taking the estimated market value of your home and subtracting whatever amount you owe on it. This is a very valuable asset, and you can use it to take out a home equity loan to repair or improve your property.
But how do home equity loans work? What can you miss out on if you're considering a loan for debt consolidation or to buy a new property, and you don't use it?
We want you to know all of your options, and we'll spell out exactly how home equity loans work, the types, how to calculate it, and much more. By the end, you'll know if this is a good option for you or if you should seek alternative options.
A home equity loan can be simply defined as a loan for a fixed amount of money. Your home secures this loan, and you make equal monthly payments to repay it over a fixed period. The payments work just like your traditional mortgage payments-- which is why this type of loan is sometimes referred to as a second mortgage. If you default on your payments, the lender can start foreclosure proceedings on your home.
The amount you can borrow has a cap of 80% to 85% of your home's equity amount. However, things like your credit history, income, and your home's market value also play a role in the actual loan amount the lender approves you for.
Home equity is determined by subtracting the amount you still owe on your mortgage from the current market value of your home.
Calculating your home equity involves two steps. For this example, we're going to say that you purchased your house 10 years ago. Today, your home has a market value of $500,000. Your mortgage is at $300,000 since you've made your payments each month for the past 10 years. This means your home has built equity.
How do home equity loans work? Before we answer this question, you have to understand that there are two types of home equity you could apply for. Now that you know how to get your home equity amount, the next step is to understand your options. We listed the two types of home equity loans below.
At its core, this is a second mortgage on your home. The lender pays you out in a lump sum. You're responsible for paying it back in monthly installments.
This is very similar to a traditional credit card. You'll have a limit on what you can borrow, and you pay the money back in monthly installments.
We mentioned that a home equity loan is a second mortgage, but what does that mean? This is a lien you take out on your home that already has a mortgage loan attached to it. A lien lays out specific circumstances in which the lender could seize or possess your property. If you default on your payments, the lender has the right to take control of your property. When you take out this second mortgage, the lien goes against the part of the property you already paid for by paying on your first mortgage.
Unlike many other types of loans, you can use your second mortgage's money to cover virtually anything from debt consolidation to repairs on the home and everything in between. Lenders who offer second mortgages usually have interest rates that come in at much lower levels than credit cards. In turn, many people use them to consolidate and pay off credit card debt.
Since the home equity loan is a second mortgage, you use your property to secure your new debt. The lender pays you your total out as a lump sum when they approve you for this loan. Once you get it, you'll have to start repaying it straight away. You'll end up paying the amount plus a fixed interest rate. It'll be the same amount every month for the loan's term, and it could stretch from 5 to 15 years.
Home equity loans are popular choices for homeowners who have immediate, large expenses. It gives you the peace of mind that comes with knowing you're going to have predictable payment amounts, regardless of what the market does in terms of fluctuations. This allows you to plan and arrange your finances well in advance.
You make your monthly payments to your lender just like you did with your mortgage payments. They're due on the same date each month. Your terms can vary from lender to lender based on the amount you borrowed, your interest, and how much you can afford to pay each month. Traditionally, terms start at five years and go up to 15 and 20 years or over.
There are a few minimum requirements you have to hit to qualify for your home equity loan. Each lender has its own set of rates and borrowing standards for their home equity loans, so it can be a good thing if you want to shop around before settling on one. You should also have a good idea of how much you want to borrow. Don't borrow more than you absolutely need to. We outlined the minimum requirements below.
If you have a credit score that dips below 620, it can be very challenging for you to qualify for a home equity loan. Lenders will look at your debt-to-income ratio, credit score, financial documents, employment, and income to ensure you won't have a problem repaying your loan. You should have all of this together ahead of time.
One of the biggest uses for a home equity loan is for a large purchase. Maybe you want to update some parts of your home, or you have a lot of debt you have to take care of. Since they have lower interest rates, they're also popular for paying off credit card debt. It's much easier to manage a single payment with a fixed interest rate than it is to try and juggle multiple payments a month.
The second option you have available is a home equity line of credit. Think of this as a credit card. It typically has an initial draw period of a decade from opening the card that allows you to pull out as much money as you need up to the credit line's limit. You'll make monthly payments to pay down your HELOC's principal balance. The credit will revolve and allow you to use it a second time. This is nice because you can pull money out as you need it.
You will pay a variable interest rate with this option, and this means that your monthly payments can fluctuate up and down over the lifetime of your loan. You can find lenders who will give you a fixed-rate home equity line of credit, but you should prepare yourself to pay a higher interest rate each month.
However, it gives you the flexibility to pay a combination of the principal balance and interest payments or interest-only payments. If you choose to pay on both the principal balance and the interest, you'll pay off your loan sooner. Once your draw period ends, whatever you have left for your interest and principal balance are due. The interest rate switches to a fixed one, and you usually have between 10 and 20 years to pay it in full.
Just like with the home equity loan, the HELOC has a set of qualifications you have to meet in order for a lender to work with you. Again, they'll vary from lender to lender, and this is why shopping around is so important. You don't want to cheat yourself out of a good rate because you went with the first lender that offered. If you're a member of a Credit Union with good standing, you're more likely to be pre-qualified and approved with a chance at a lower APR. The basic qualification requirements are below.
The lower your credit score is, the less likely it is that a lender will take a chance and offer you a HELOC. If you do qualify at a lower credit score, you'll pay for it with much higher interest rates because the lender sees you as very high-risk for defaulting before you pay it in full.
Since you usually get a 10 year draw period to pull funds whenever you need it, the HELOC is good for home repairs and renovations. You can renovate parts of your home to increase the overall value, or you can improve your home's appearance both inside and out. Adding more efficient features like new appliances or energy-saving lighting is a good use, and many people use this money to pay off their debt because it's easy to consolidate everything into one payment.
Now that we've covered the basic concepts of home equity loans, we'll go over the pros and cons to make sure you're able to make the best decision for your situation. While these won't be deal-breakers for many people, it can help you make your final decision easier.
If you don't qualify for either of these options or you don't want to risk your home, there are alternatives available to you. Two main ones come to mind, and they both have their own pros and cons associated with them.
Unlike a second mortgage that you pay on top of your existing mortgage with a home equity loan, a cash-out refinance of your home replaces your current mortgage. It increases the total you owe up over your home's actual value. This is the portion of the money that you can cash out. Once you do, you can spend it on whatever you need with no restrictions.
The second option is a personal loan. Credit Unions, banks, and online lenders all offer them for various amounts. They'll typically be less than what the other options offer, but they can be more flexible with the borrowing requirements. You can use the money for anything, and they have a fixed and flexible interest.
Those are the basics of how home equity loans work. Are you ready to learn more about a home equity loan or a HELOC? If so, reach out and get in touch. Our staff is ready to guide you through the process and help you get the funding you need. Be sure to check out our HELOC service page and use our HELOC Payment Calculator!
Are you still confused or undecided on wether this type of loan is the right move for your current financial situation? 121FCU members receive FREE financial counseling and guidance.