How Does A Home Equity Loan Work? All You Need To Know

Getting a home equity loan or a home equity line of credit is beneficial if you’ve been wanting to remodel a part of your house or have an unexpected home repair to make. Wondering how does a home equity loan work? Read on to get detailed insights on home equity loans.

If you are a homeowner and have taken out a mortgage loan, you must have come across the term home equity now and then. Home equity is actually the amount of your house that you actually own. Surprisingly, not many homeowners or mortgage borrowers are aware of their house’s actual worth and how they can profit off of it through home equity loans. If you too are a homeowner and want to know a thing or two about home equity loans, follow this guide to learn how a home equity loan works.

Home equity builds over time as you continue paying your mortgage balances and add value to your home. Home equity can be the most valuable asset as it can be used to borrow home equity loans or lines of credit.

Home equity financing is when you use your home as a collateral when you borrow money and secure the financing with the value of your home. In easy words, if you are unable to pay the financed amount back, the lender can take your home as a payment for your debt and you might end up losing your home to foreclosure. So, it’s important to know all the deep-down details of home equity loans before getting one.

Another important thing to keep in mind while trying to get a good deal on home equity loans or home equity line of credit is to shop around and get some research done. You can compare different financing options offered by banks, mortgage companies, and credit unions to get a better idea. No matter how much information you have gathered from the internet, it is always best to visit expert institutions to get first-hand knowledge.

This article will let you know how a home equity loan works and what benefits and drawbacks come with these loans. By the end of the article, you’ll have clearly understood the topic and the basic details to get started with a home equity loan.

What is a home equity loan?

A home equity loan is also sometimes referred to as an equity loan, second mortgage, or home equity installment loan. It is a type of consumer debt that is secured by your home and can be used to consolidate debt or pay for large expenses, such as home improvements, education, or purchasing a vehicle. If you’ve got an unexpected home repair to make, you can make use of the equity in your house by getting a home equity loan.

This type of loan allows homeowners to borrow against the equity in their homes where the loan amount is based on the difference between the home’s current market value and the amount of debt left to be repaid. In other words, home equity is the appraised value of your home minus the outstanding mortgage and loan balances.

The loan amount is paid back through equal monthly payments over a fixed term. Home equity loans have both the interest rate and monthly payment fixed which ensures a predictable repayment schedule. The amount that you can borrow and the interest rate that you get on the home equity loan depends on your income, credit history, and the market value of your home, which is the most important factor. Most of the time, lenders prefer that you borrow no more than 80 percent of the equity in your home.

It is important that you shop around for a while before closing on a lender to get a home equity loan. You can consider your current lender as well and see what they offer. Who knows, you might even get a deal from your current lender on the interest rate or fees. Or you can ask friends and family for any recommendations for home equity loan lenders. Look for some traits that make them stand out as an excellent lender. Do your own research and negotiate a deal that works best for you.

Home equity loan requirements

In order to get your home equity loan application approved while getting your hands on the best deal, you need to fulfill some requirements that lenders impose on borrowers. Although each lender, bank, or credit union will have its own requirements, most borrowers will generally need the following in order to proceed with approving your home equity loan.

  1. A certain percentage of home equity: Make sure to have 15 percent to 20 percent equity in your home. Since equity is the difference between how much you owe on your mortgage and the home’s current market value, lenders use this number to calculate LTV or loan-to-value ratio. LTV is an important factor that helps determine your qualification for a home equity loan. If you do qualify, LTV also determines how much amount you can borrow.
  2. Good credit score: Your credit history is used by creditors to help decide whether to give you the requested credit. The information being evaluated includes your bill-paying history, the number and type of accounts you have, outstanding debt, late payments, etc. your credit score predicts how likely it is that you’ll repay the loan and make the payments on time. So, most of the lenders require a credit score of 600 or above.
  3. Verifiable Income history: for creditors to approve your application for home equity loans or a home equity line of credit, you need to have a verifiable income history of two or more years. This helps the lenders get assured that you have a consistent income history that you can maintain in the future to eventually pay off the loan amount.
  4. Low debt-to-income (DTI) ratio: You are more likely to get approved for a home equity loan if you have a low debt-to-income ratio. DTI ratio requirements vary from lender to lender, ranging from 36 percent, 43 percent, or even 50 percent. The lower the DTI percentage, the better.

These are some of the requirements you need to fulfill to get your home equity loan approved. Although it is possible to get your loan approved without meeting these requirements to their fullest, chances are that you will end up getting a much higher interest rate.

How to build home equity?

As described earlier, home equity is the difference between your home’s current market value and the due mortgage amount that’s left to be paid. This is the number that you’ll receive, so you need the home equity percentage to be as big as possible. In fact, there are a few circumstances that can help you to build up and increase your home equity.

Mortgage payments

This is the easiest way to increase your home’s equity. When you make monthly mortgage payments, you are actually reducing the outstanding balance on your mortgage. With every installment, you are paying down your mortgage balance and increasing your home equity. Apart from your monthly payments, you can even pay additional mortgage payments to build your equity even faster.

Property value growth

Although it might not happen every time, most of the time, property value increases with time, which is referred to as appreciation. This is another way to build your house equity. But appreciation doesn’t happen with every property and also depends on various factors such as your property’s location and the economy, etc. So, staying in your house for long just to expect a decent rise in value might not always help. If your area has a history of price hikes, the growth in your property value might help in building equity.

Your property can also grow in value if you have made some home improvements that add to its overall value. This is yet another way to increase your home equity while keeping the mortgage principal balance the same. However, keep in mind that some home renovations add more value than others. So if you are doing renovations in order to build equity, make sure to do proper research before starting a renovation and be certain that the renovation will be worth the time, effort, and money in the end.

Large down payment

Making a large down payment can also help you build up your home equity. When you make a large down payment, the amount you owe or the mortgage balance will automatically decrease. This will result in a bigger number when the difference between your home’s value and the amount you owe will be calculated. And you will end up increasing your home equity. Moreover, it will also allow you to tap your home equity faster because lenders usually require you to have 20 percent equity in your home.

How does a home equity loan work?

A home equity loan is similar to a mortgage in many ways, hence it’s called a second mortgage. Some people get confused over the term ‘equity loan’. In simple words, it is a loan in which the equity in your home serves as collateral for the lender. In such loans, the homeowner is allowed to borrow the amount which is partially based on the combined loan-to-value (CLTV) ratio.

Essentially, home equity loans have a fixed repayment term, just like conventional mortgages. The borrower is inclined to make regular, fixed payments covering both principal and interest rates. You can use a home equity loan calculator to get an idea of the estimated monthly payments and interest rates. If the loan is not paid off, the home could be sold as payment for your debt and you might end up losing your home to foreclosure.

Home equity loans are a good way to make use of the equity that you have built up in your home and turn it into cash. You can invest that cash in home renovations, educational expenses, consolidating your personal debt, or any emergency costs. Such loans are extremely beneficial if you are using your home equity in home renovations that further increase the value of your home. However, keep in mind that you are putting your home on the line and if real estate value decreases, you could end up owning more than your home’s worth.

How to calculate home equity?

If you are thinking about getting a home equity loan, make sure to calculate your home equity first. Down below, we have listed two simple steps to calculate your home equity.

  • Step 1: First of all, you will have to get your home’s estimated current market value. Your home is not of the same value as it was when you first bought it. You will find many price estimator tools online but it is always best to talk to a real estate agent to get a more accurate estimate of your home’s market value. In most cases, a lender might even order a professional property appraisal to determine your home’s market value.
  • Step 2: Make notes of the amount that you still owe on your mortgage or any other debts secured by your home. Once you have got the correct estimate of your home’s market value, subtract the outstanding mortgage and loan balances from that value. The resulting difference is your home equity.

Advantages of home equity loans

Essentially, there are a number of benefits to taking out home equity loans. These loans can provide an easy source of cash and can be a valuable tool for responsible homeowners who are in need of large sums for home improvement, debt consolidation, or any other purpose. If you have a steady and reliable source of income and also fulfill other requirements of home equity loans, you can benefit from the following things.

Low interest rates

Home equity loans of home equity lines of credit are secured by your home.. Even though the interest rate is higher than the first mortgage, it is much lower than that of unsecured loans such as consumer loans or credit cards. This way, you can save on interest payments and improve monthly cash flow if you need to lower the debt that has high interest rates.

Tax benefits

According to the 2017 Tax Cuts and Jobs Act, homeowners are allowed to deduct the interest on home equity loans or lines of credit if the cash is used for capital improvements, such as to ‘buy, build, or substantially improve the home that secures the loan.

Relatively simple and easy process

For many homeowners, getting a home equity loan is quite simple because it is a secured debt. The process might include the lender running a credit check and ordering an appraisal of your home to determine the borrower’s creditworthiness and the combined loan-to-value (CLTV) ratio.

Disadvantages of home equity loans

The thing with home equity loans is that they won’t work for everyone in every situation. So, before you commit to using home equity, make sure to go through their drawbacks or disadvantages as well.

Risk of losing your property

One of the biggest disadvantages of getting home equity loans is the risk of losing your home as a result of a foreclosure. Home equity loans are secured by your home, so if you fail to repay your debt, your lender can foreclose it and keep your home to compensate for the loss. If your house drops in value, you could also end up owing more on your home than it’s worth. Hence, it becomes more difficult to sell your home if you need to.

Loan borrowing costs

Sometimes, lenders charge fees for granting you home equity loans. So, it is important to pay attention to the annual percentage rate (APR), which includes the interest rates and other loan fees. As a result, you might end up paying a high interest rate.

Misuse of home equity money

Home equity is best used to finance expenses that will pay you back, such as renovating a home to increase its value, renovating the home to add to its value, paying for college, starting a business, or consolidating high-interest debt. However, some homeowners might want to use the home equity cash simply for luxuries that won’t end up valuable. These include taking a vacation or purchasing luxury items. If you are also spending your home equity on such things, you might end up being disadvantaged from home equity loans.

Ending thoughts

Conclusively, home equity is a great financial tool that can help you in paying off big expenses like home renovation, high-interest debt consolidation, and education costs. It can be a good choice for those who know exactly how much equity they need to pull out and want the security of a fixed interest rate.

If you are looking forward to a large amount of cash, you may want to consider borrowing some of the equity that you have built up in your home. However, you should do so with care and look around multiple lenders before signing up. It is important for borrowers to take out home equity loans with caution. Because otherwise, you can easily end up underwater on a mortgage if too much equity is pulled out or if it’s done with little to no knowledge of details, resulting in a borrower ending up with ruined credit or losing their property.

For you to understand better, this article has covered all the details on how does a home equity loan work and what are the pros and cons of cashing out your home equity with such loans.

John Otero

John Otero

John Otero is an industry practitioner with more than 15 years of experience in the insurance industry. He has held various senior management roles both in the insurance companies and insurance brokers during this span of time. He began his insurance career in 2004 as an office assistant at an agency in her hometown of Duluth, MN. He got licensed as a producer while working at that agency and progressed to serve as an office manager. Working in the agency is how he fell in love with the industry. He saw firsthand the good that insurance consumers experienced by having the proper protection. John has diverse experience in corporate & consumer insurance services, across a range of vocations. His specialties include Major Corporate risk management and insurance programs, and Financial Lines He has been instrumental in making his firm as one of the leading organizations in the country in generating sustainable rapid growth of the company while maintaining service excellence to clients.