How Does a Home Equity Loan Work?

What is a Home Equity Loan?

A home equity loan is a lump-sum installment loan guaranteed by the equity in your home. Also known as a second mortgage, the loan uses the equity in your home as collateral.

The loan is a fixed-rate installment loan, which is where the borrower will pay a monthly principal and interest payment for the life of the loan. Unlike a home equity line of credit (HELOC), a home equity loan is not an open line of credit that the borrower can continuously draw from. Instead, the borrower receives an up-front lump-sum and agrees to repay both the principal and interest over an agreed upon term.

Home equity loans can range from 5 to 30 years and are ideal for borrowers requiring a lump-sum loan.

How Much Can You Borrow?

To determine the amount you can borrow, you first need to determine the equity in your home. That’s done by using the appraised value of your home, minus the amount you currently owe on the home.

Example: Your home appraises for $400,000 and your current mortgage balance is $250,000. Therefore, the equity in your home is $150,000.

In addition to the equity in your home, lenders will also determine the amount you can borrow based on your creditworthiness. This is known as the combined loan-to-value (CLTV) ratio.

Example: Let’s assume the lender approves you for 85% maximum combined loan-to-value for your loan based on your creditworthiness. If your current home appraises for $400,000 and your mortgage balance is $250,000, then you would have received a home equity loan up to $90,000.

Just as you would expect with any other installment loan, the lender will determine the eligibility, terms and interest rate of your loan based on factors such as your income, assets, liabilities and credit score.

Home Equity Loan Versus a HELOC

If you recall, a home equity line of credit (HELOC) is very similar to how a borrower uses a credit card. The HELOC offers an open line of credit that the borrower can continuously draw from and repay the balance at any time during the draw period of the loan.

The interest rates for HELOCs are often variable rate loans and the monthly principal and interest payments change based on the monthly balance on the HELOC.

Home equity loans are just the opposite. Instead of an open line of credit, the borrower receives an upfront lump-sum payment. As far as repayment, a home equity loan uses a fixed interest rate with a fixed monthly principal and interest payment. A HELOC on the other hand offers a variable interest rate during the draw period and a fixed interest rate during the repayment period.

4 Reasons to Use a Home Equity Loan

The good news with a home equity loan is you are free to use the funds for whatever you choose. While there are things you should avoid, here are the most common reasons to get a home equity loan.

1. Home Improvements

Among the most common reasons to get a home equity loan is for home improvements. For starters, it makes sense to use the equity in your home to improve the home you live in. Maybe that’s a pool, an updated kitchen, or a bathroom remodel. Another perk is that the IRS allows the borrower to deduct the interest paid if the borrower uses the funds to improve the home that secures the loan.

2. Debt Consolidation

If you are currently trying to get out of debt, it can be painfully slower than you’d like. One way to speed up the process is to trade a higher interest rate for a lower interest rate. This may look like consolidating high interest credit card debt for a low interest home equity loan. However, keep in mind you’re also trading unsecured debt for debt that is now secured by your home.

3. College Expenses

While student loans are the most common way to pay for college, a home equity loan may be a better option. That’s because rates on a home equity loan are often lower than student loan rates. Another advantage is that home equity loans often have longer terms than student loans, therefore making the payment more manageable each month.

4. Wedding Expenses

With the average cost of a wedding in 2020 at $19,000, a home equity loan may be the best option if you don’t have the cash set aside. Home equity loans offer much lower interest rates versus a credit card or even a wedding loan for that matter.

4 Reasons to NOT Use a Home Equity Loan

A home equity loan is not always the best option when used incorrectly. Here are a few instances where you may want to consider an alternative to a home equity loan.

1. Pay for Monthly Bills

If you are facing monthly cash flow problems, it may seem like a good idea to take out a home equity loan. However, this may cause things to get worse since you’re only treating a symptom of the bigger problem: living within your monthly budget.

Also, a home equity loan will eventually exacerbate your monthly cash flow problems with the addition of a new monthly principal and interest payment.

2. Pay for a Vacation

While it’s not a good idea to go into debt for a vacation, it’s definitely not a good idea to use debt to go on a vacation when the debt is guaranteed by your home. Using debt to fund leisure and entertainment activities is often a symptom of poor money management. It’s better to save up and pay cash for a vacation.

3. Buy a Car

Sometimes borrowers will use their home equity loan to “pay cash” for a car. While this may seem like a good idea, this is not a smart financial move. An auto loan is a much better option because of how the loan is secured. If the borrower fails to make payments on the auto loan, the car is at risk. If the borrower fails to make payments on the home equity loan, the house is at risk.

4. Emergency Fund

The best emergency fund is the cash option. However, saving up 3 to 6 months of emergency expenses may take a while and you may feel a home equity loan is a good option. Keep in mind the borrower immediately starts making payments on the home equity loan, even when not using it for an emergency expense. Therefore, a home equity line of credit would be a better alternative for an emergency fund. Remember, interest on a HELOC only accrues once a draw is made from the line of credit which differs from a home equity loan.

Check out the other posts about home equity loans!