What is a Home Equity Loan?
A home equity loan, also called a second mortgage or a home equity installment loan, is a consumer loan allowing borrowers to take out a loan against the real estate's equity.
The amount of this type of loan depends on the difference between the real price of real estate on the market and the current mortgage balance of the borrower.
The home equity loans come with fixed interest rates and home equity line of credit (HELOC), which has variable rates. Fixed-rate equity loan allows to borrow money once, and a home equity line of credit comes with a revolving line of credit.
How Does a Home Equity Loan Work?
Another name for a home equity loan is the second mortgage since the basic principles of these types of loans are similar. In a home equity loan, the borrower's real estate is collateral for a bank, lender, or other financial institution. The property is transferred to the lender's ownership if the borrower cannot repay the loan. The lender will sell the property and will not lose profit. The loan amount is calculated partly from the combined loan-to-value (CLTV) ratio of 80% to 90% of the real estate's estimated value. Also, the available loan amount for the borrower is affected by their credit score and payment behavior when mortgaging or renting housing. A home equity loan with a fixed rate has a certain repayment term, just like a traditional mortgage. The borrower must pay fixed monthly payments, which consist of principal and interest.
Home equity lines of credit are an alternative to home equity loans that allow the borrower to get revolving lines of credit. The borrower takes a certain amount according to his credit limit, returns it, and can take a new amount. The draw period most often ranges from 5 to 10 years. After this period, there comes a repayment period of 10 to 20 years in length, during which it is impossible to withdraw money. Usually, HELOC has a variable rate, but some lenders may offer a home equity line of credit with a fixed interest rate.
Home equity loans and HELOCs allow the borrower to convert the home's equity into cash to cover various bills. This loan option is ideal for paying for home renovations and installation improvements, as it increases the house's value on the market. The borrower can also use the amount received from the home equity loan for other purposes. For example, close credit card, medical, or college bills. Also, the borrower can make a debt consolidation.
However, the borrower should remember that this type of loan is quite risky. A home equity loan should be considered as the last option to find the right amount of money in an emergency since the borrower risks losing the house if they have problems with work, for example. If the borrower used home equity to pay for another loan, then they should not take out a new loan since the home equity loan's repayment term can reach up to 30 years.
Home Equity Loan vs. HELOC
Home equity loans and home equity lines of credit (HELOCs) are two different types of loans that allow homeowners to borrow against the equity in their homes. While both types of loans are based on the same principle, they have several key differences that homeowners should understand before choosing one over the other.
A home equity loan is a lump-sum loan that provides a fixed amount of money all at once. You'll receive the entire loan amount in a single payment and then make regular monthly payments to repay the loan. Home equity loans typically have a fixed interest rate, which means that your monthly payments will remain the same for the life of the loan. This can be beneficial for homeowners who need a fixed monthly payment for budgeting purposes.
On the other hand, a HELOC is a line of credit that gives you access to a set amount of credit that you can use as needed. You'll only pay interest on the amount you borrow and can repay the loan in full or in part at any time. HELOCs have a variable interest rate, so your interest rate can change over time. This can be a challenge for homeowners who need to budget their monthly payments.
Another key difference between home equity loans and HELOCs is the way they are used. Home equity loans are typically used for large, one-time expenses such as home renovations, college tuition, or medical expenses. HELOCs, on the other hand, are used for smaller expenses or for ongoing expenses such as home repairs, medical bills, or other unexpected expenses.
The interest rate on a home equity loan is typically fixed, while the interest rate on a HELOC is typically adjustable. This means that with a home equity loan, the interest rate will remain the same for the entire repayment period, while with a HELOC, the interest rate can change over time.
The repayment period for a home equity loan is usually fixed, typically ranging from 5 to 15 years. With a HELOC, the repayment period is usually open-ended, allowing the borrower to access funds as needed for a set period of time, usually 10 years.
The loan amount for a home equity loan is typically based on the equity in the property, with lenders typically lending up to 80-90% of the property's value. With a HELOC, the loan amount is based on a percentage of the property's value, typically around 80%, and the borrower can access funds as needed up to the maximum credit limit.
Home equity loans are ideal for borrowers who need a lump-sum payment for a one-time expense, while HELOCs are ideal for borrowers who need access to funds as needed. When choosing between the two, consider your financial situation, the amount of equity in your property, and your future financial goals. Shop around and compare offers from multiple lenders to ensure you're getting the best terms and interest rate. By understanding the differences between a home equity loan and a HELOC, you can make an informed decision and achieve your financial goals.
Pros and Cons of Home Equity Loans
Pros
- Lower interest rates. Home equity loan rates are often have lower compared to other forms of loans, making it a more affordable option for borrowers.
- Tax deductible. The interest paid on a home equity loan may be tax deductible, providing a tax benefit to borrowers.
- Access to large sums of money. Home equity loans allow borrowers to access a large sum of money, which can be useful for financing major expenses such as home improvements, medical bills, or debt consolidation.
- Fixed repayment terms. Home equity loans often have fixed repayment terms, which provide certainty and stability to borrowers.
Cons
- Risk of foreclosure. If a borrower fails to make payments on a home equity loan, their home may be foreclosed upon, putting their primary residence at risk.
- Higher closing costs. Home equity loans often come with higher closing costs compared to other forms of loans, which can add to the overall cost of borrowing.
- Tied to the value of your home. The amount of money you can borrow through a home equity loan is tied to the value of your home, which means that if the value of your home decreases, your borrowing power may also decrease.
- Long-term commitment. Home equity loans often have longer repayment terms compared to other forms of loans, which means that borrowers are committed to making payments for a longer period of time.
How to get a home equity loan
If you consider taking a home equity loan, here is a step-by-step guide on how to get started:
- Determine your eligibility. To qualify for a home equity loan, you must have built up equity in your home and have a good credit score. Your credit history and the value of your home will be considered when determining the loan amount and interest rate. You can check your credit score for free at several websites, including AnnualCreditReport.
- Determine the amount of equity you have in your home. You can determine the amount of equity you have in your home by subtracting the amount of your mortgage from the appraised value of your home. The amount of equity you have will determine the amount you can borrow.
- Shop around for lenders. There are many lenders that offer home equity loans, including banks, credit unions, and online lenders. Shop around to compare interest rates, loan terms, and fees to find the best lender for you.
- Gather the necessary documents. To apply for a home equity loan, you'll need to provide the lender with some basic information about your financial situation, including your income, expenses, and debt. You may also be required to provide proof of income, such as your W-2s or pay stubs, and documentation of your assets, such as bank statements.
- Complete the loan application. Once you've found a lender, you can complete the loan application and provide the necessary documentation. The lender will then review your application and determine if you're eligible for the loan.
- Get approved. If you're approved for the loan, the lender will provide you with a loan estimate that outlines the terms and conditions of the loan, including the interest rate, loan amount, and repayment period. Review the loan estimate carefully to make sure you understand the terms and conditions of the loan.
- Close the loan. If you accept the terms and conditions of the loan, you'll sign the loan documents and close the loan. The lender will then disburse the funds, which you can use for the purpose for which you took out the loan.
- Repay the loan. You'll need to make monthly payments to repay the loan, which will include both interest and a portion of the principal balance. The amount of your monthly payment will depend on the interest rate, loan amount, and repayment period.
Ways to Pay Home Equity Loan Back
If you've taken out a home equity loan, it's important to understand the various options for repaying the loan. Here are some ways to pay back a home equity loan:
- Fixed Monthly Payments. This is the most common method of repayment for a home equity loan. You'll make a set monthly payment that includes both interest and a portion of the principal balance. The amount of your monthly payment will depend on the interest rate, loan amount, and repayment period.
- Balloon Payment. With a balloon payment, you'll make smaller monthly payments for a set period of time and then make a large lump sum payment to pay off the remaining balance at the end of the loan term. This type of repayment is typically used for short-term loans.
- Interest-only Payments. With this type of repayment, you'll only make interest payments for a set period of time. After that period, you'll begin making payments that include both interest and a portion of the principal balance. This type of repayment is typically used for short-term loans or for borrowers who are in a tight financial situation and need to lower their monthly payment.
- Refinance. If you have a large amount of equity in your home and your financial situation has improved, you may be able to cash-out refinance your home equity loan into a new loan with better terms and a lower interest rate.
- Sell your home. If you have a significant amount of equity in your home, you may be able to sell your home and use the proceeds to pay off your home equity loan. This may be a good option if you no longer need the loan or if you're facing financial difficulties and need to free up cash.
