How Home Equity Loans Work: Pros, Cons, and How To Use Your Home’s Equity

Shelly Bohorquez
Woman showing man how a home equity loan works

As a homeowner, you’ve invested in a property of a certain value that you are paying off through a home loan. As you pay off your mortgage, you begin to build equity from your home, which is the difference between what your home is worth and how much you still owe on it. As you pay your house off and increase the equity, you create access to a type of loan that banks are willing to offer you if you maintain good financial standing.

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What Is a Home Equity Loan?

A home equity loan is essentially a loan that you receive by using your home as collateral for the bank. Once you’ve paid off a significant amount of your home, or your home has appreciated in value, you can use the money you’ve invested in your property to invest in other areas, such as home renovations, paying for school, or even paying off high-interest credit cards.  

Home Equity Loan vs Mortgage

There are a few differences between a mortgage and a home equity loan, mostly regarding the terms and use of these loans. A mortgage is a loan that a potential homeowner receives from a bank in order to purchase a home. Mortgages are typically for 80 percent of the home’s appraised value, and they can have either a fixed interest rate, or a variable interest rate that may change each year. The loans are paid over a fixed term of typically 15 or 30 years.

You are only eligible for a home equity loan after you’ve purchased a house and built equity on it. Home equity loans are a type of second mortgage on your house, because once you’ve borrowed the money, you risk losing your home if you don’t make the loan payments, even if you are still paying your mortgage. Home equity loans, like traditional mortgages, are paid over a fixed term as well.

Home Equity Loan vs Line of Credit

A home equity loan and a home equity line of credit are closely related, both borrowing money from your home equity. The main difference between these two types of loans is that a home equity loan is received as a lump sum that is paid back over a set period of time, whereas you can continuously borrow from a home equity line of credit as needed, and pay it back through monthly payments. Your ability to take only what you need from a line of credit makes it the less expensive option of the two, if you only need to use your home equity for a small amount of credit.

The main reason you would use one over the other simply depends on what you’re looking to accomplish with the money. If you’re hoping to make large scale renovations in your home to increase its value, borrowing a lump sum may be the more efficient option. If the reason you’re borrowing money is for anything aside from home improvements, you should consider whether it’s worth using your home as collateral.

How Does a Home Equity Loan Work?

How Much Equity Can I Borrow From My Home?

Home equity loans are low risk investments for bank, as the loans are secured with collateral. If you don’t pay the loan, you risk the bank foreclosing your home to get paid. That being said, lenders often limit home equity loans to 80 percent of your cumulative loan-to-value, and like any other loan, you are only eligible for this if you have good credit, with a score that is typically above 620.

Home Equity Loan Interest Rates

There are two different kinds of home equity loan interest rates; variable and fixed. Variable interest rates fluctuate over time as they are based on an underlying index that changes with the market. This would be the better loan option to have during times when interest rates have dropped, however, it may be more difficult to keep up with if interest rates rise. A fixed interest rate is preferred at times, simply because the lender knows what to expect from their payments.

Interest rates for home equity loans depend on your credit, but are usually pretty low (around 5 percent) if your credit is up to par, which can make a fixed rate appealing. However, when shopping around for a loan, you should also pay attention to the annual percentage rate (APR) you are being offered, as this encapsulates not only the interest rate, but other costs such as broker fees, discount points and some closing costs, expressed as a percentage. When shopping for a loan, discuss these points with lenders to see who will give you the best deal to meet your needs.

Costs of a Home Equity Loan

Home equity loans, like any other loans, can have thousands of dollars associated in fees and closing costs. These fees are assessed by looking at the APR of a loan, as this percentage gauges how much you will pay for the loan over its lifespan. If you intend to pay the loan off over the dedicated period of time, a low APR will ensure you pay the least amount possible for the loan, as the fees are spread throughout the life of the loan. Factor into the overall cost of the loan. However, if you take out the loan with the intention of selling the house to cover loans costs, a higher APR is not as important because you won’t pay the loan fees throughout the entire life of the loan.

Can You Use a Home Equity Loan for Anything?

Home equity loans use your home for collateral to secure a large loan with a low interest rate. While this can be a good loan option for important purchases, home equity loans should not be used lightly. The most common uses for these loans are to make home improvements, to consolidate debt, to fund education, or make major purchases or investments. Home improvement are most common because they add value to your home, which can make a big difference if you plan to sell. It can also be a smart fiscal move in order to get out of debt or make major purchases without the high interest rates of unsecured loans.

Paying Off a Home Equity Loan

Before taking out a home equity loan, it’s important to assess your financial situation to ensure you can pay off the secured loan. If you don’t have a good reason to take out an additional loan, it’s usually better to avoid it, as unforeseen financial troubles could put you at a greater risk of foreclosure. If money is tight, an additional debt is not another circumstance you want to worry about, so make sure your spending habits will not interfere with your ability to pay off the loan.

How To Get a Home Equity Loan

Home Equity Loan Requirements

To be eligible for a home equity loan, you will need to have accrued a certain amount of equity in your home, although the required amount depends on the lender you go through and the size of the loan you’re hoping to receive. Like with any other loan, you’ll need to have good credit to be given the opportunity to finance a loan.

Before you meet with a lender, there are a few ways to prepare to apply for the loan in order to have the best possible outcome. Start by checking your credit, and taking care of any small outstanding bills that may be affecting it. A high credit score will help you receive the best possible deal from the lender and will make it easier for you to negotiate rates. Meet with a few different lenders, as fee structures can vary widely between banks, and see if they can match the deals other lenders are offering.

Home equity loans are a good opportunity for homeowners to make fiscally advantageous investments and purchases by using their homes to secure a loan. Although these loans should be taken with caution because they are an additional debt on your existing mortgage, they can be used for a variety of reasons that are ultimately up to the homeowner. If you’re looking to make new investments, do you research and shop around to find the best home equity loan available to you.

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