Home equity loans can be a great way to help you take your next step, whether it be to a new car, to home renovations or to any other large purchase.
While car loans are the most common type of secured personal loans, a vehicle isn’t the only way to guarantee a loan. If you own your own home and have built up some equity in it, you can use that equity as a guarantee on your next loan. Find out how it works in this guide.
How does a home equity loan work?
A home equity loan works the same way as other secured personal loans. When you apply you will need to provide details of your mortgage, your personal financial position and the reason you’re taking out the loan. Your application will be assessed and if approved, you will be given a loan based on how much equity you hold and how much the lender thinks you can afford to repay.
How much you own in your home will be used as collateral for the loan. If you were to default on the loan, the lender could recoup its losses by taking ownership of that equity.
Home equity is essentially the difference between your property’s value and any debt you hold against it. This means if your home is worth $500,000 and you have a mortgage of $250,000, you have $250,000 worth of equity in your home. With a home equity loan, you can typically borrow up to 80% of the value of your home, minus your mortgage.
How much can I borrow?
Here’s how to figure out how much you can borrow with a home equity loan:
Take the value of your home and deduct any amount you still owe towards your mortgage.
Multiply this number by 0.8 (0.8 represents the maximum amount of 80%).
Multiply this number by 100 and you have the maximum amount that you may be able to borrow.
Types of financing you can secure with your home equity
The types of loans available when using your equity give you real flexibility:
Fixed-term secured loan.A secured loan is guaranteed by collateral you put up and can be used for any purpose. It is given to you in a lump sum and you pay it back in installments, usually over a period of 1-7 years. As the loan is secured you can enjoy a more competitive rate.
Line of credit. As a continuous source of credit, you can draw on this loan as and when you need to. You’ll have access to the amount of credit that you’re secured for and be required to make regular repayments and as you repay the credit it will become available again. You may see this product marketed as a HELOC, or Home Equity Line of Credit.
Is a home equity loan the same as a home equity line of credit (HELOC)?
Not quite. While both types of financing draw from your equity as a source of collateral, a home equity line of credit (HELOC) functions more like a credit card. You have a large amount of money you can draw from at any time for the loan period, usually 5 to 15 years.
A home equity loan usually has the same repayment period, but you’re advanced the lump sum immediately. Because of this, you must pay interest on the entire amount (like a regular mortgage). On the other hand, if you take out a HELOC, you only have to pay interest on the amount you borrow from the possible pool of funds — say $50,000 of the total $100,000.
What kind of purchases and investments can you make with a home equity loan?
While the loans themselves are secured, there aren’t many restrictions on how you use your loan. You can use the money for:
Competitive interest. Your loan is secured by a valuable and appreciating asset, your property, so you will usually get a competitive interest rate.
Flexible loan purpose. You can usually use the loan amount for whatever purpose you need.
Do you need to apply with the same lender you have for my mortgage?
No, you don’t. If you decide to apply with a different lender you will need to provide details of your mortgage, including your total loan and how much equity you hold.
Is there anything else to consider before applying?
This is a risky type of loan should you default. Failing to repay the loan could result in the lender taking the equity you have in the property to pay the loan. Before you apply, consider how financially stable you are and if this is the right type of loan for you to take out.
A home equity loan can offer you a low interest rate as well as a flexible way to finance a personal purchase.
Frequently asked questions
Yes. Because home equity loans are secured by using your house as collateral, they come with very low interest rates and long repayment periods. As long as you make regular payments on the interest and principal of your loan, there’s very little associated risk.
However, it’s important to keep in mind that home equity loans were part of the reason for the financial collapse in the US in the late 2000s. Failure to repay your loan leads to defaulting, and defaulting leads to foreclosure. Always be sure you have the ability to repay before taking out a loan against your home.
There are 2 factors lenders consider when determining if they are willing to extend a loan to you.
First is your total debt. Your lender will add up everything you owe and how much your monthly repayments cost. If they see you have the ability to make the minimum payments after this, you’re more likely to get a loan.
Second, and most important, is your credit score. Just because you have the ability to repay doesn’t mean you will, and financial institutions rely on your credit history to see if you have a background of handling your debt well. A good credit score is crucial when taking out a home equity loan.
It’s possible. Since lenders use both your credit score and your total debt to determine your ability to repay, if you have a low debt threshold, you may be able to qualify for a small amount. If you don’t, you can try debt consolidation to build your credit up before you apply. It will take longer, but a good credit score is an excellent way to show you have what it takes to pay back your loan.
Kyle Morgan is a producer for finder.com who has worked for the USA Today network and Relix magazine, among other publications. He can be found writing about everything from the latest car loan stats to tips on saving money when traveling overseas. He lives in Asbury Park, where he loves exploring new places and sipping on hoppy beer. Oh, and he doesn't discriminate against buffalo wings — grilled or fried are just fine.
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