HOW DOES HOME EQUITY LOAN WORK? TYPES AND DETAIL EXPLANATION

Home equity loan, also known as a second mortgage, is a type of loan that homeowners can obtain by leveraging the equity in their homes.

It is a one-time consumer loan where homeowners can offer their homes as collateral to obtain the loan.

The amount of loan depends on the difference between the value of the home being offered as collateral and the current balance on the mortgage of the home.

For example, for a house that is worth $250,000 with a remaining mortgage of $150,000, the available home equity will be $100,000.

Homeowners obtain home equity loans for different reasons. The most popular reason for obtaining the loan is to make improvements or decorate their homes.

Homeowners also use the loans obtained for reasons not relating to their homes as there is no condition to the usage of loan.

Homeowners can also use the loan to compensate for other major expenses or to consolidate high-interest debt.

As a home equity loan is secured, due to the home offered as collateral, the interest rates on home equity loans are lower as compared to other unsecured loans.

This makes home equity loans an attractive source of debt. Home equity loans can also provide tax deductions for homeowners and, therefore, provide an extra benefit for taxpaying homeowners.

Types of Home Equity Loan

There are two types of home equity loan that homeowners can obtain.

Fixed-rate Home Equity Loan

A fixed-rate home equity loan is the type of home equity loan in which the interest rate of the loan remains fixed. In this type of loan, the homeowners are provided with a lump sum amount.

This amount is then repaid over a period of time with a constant interest rate. This makes it easier to calculate the number of payments made by the homeowners as the interest rate and payments is fixed every month over the lifespan of the loan.

Usually, fixed-rate home equity loans are provided for a period of 5 to 15 years.

This is a great home equity loan type for homeowners looking for a lumpsum amount of cash.

Homeowners can receive a lump sum of cash which they have to pay back at the conclusion of the loan period or when the home is sold, whichever comes earlier.

Since the interest rates are fixed, it can also be great for homeowners who have a mortgage with a high-interest rate.

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Home Equity Line of Credit (HELOC)

In this type of home equity loan, homeowners can borrow any amount at any given time under a set borrowing limit, known as the line of credit.

Homeowners do not receive a lump sum payment as with fixed-rate home equity loans, but instead, they are given a limit and can borrow amounts at any time during a limited draw period as long as the aggregate borrowed amount is under the set limit.

However, this type of home equity loan does not have a fixed-rate and the interest rates fluctuate according to the market interest rates.

Under this type of home equity loan, if the loan amount is repaid, it can be obtained again as long as the aggregate amount of the loan is lower than the set limit and the withdrawal time limit has not passed.

This is unlike the fixed-rate home equity loan where any loan amount repaid cannot be taken back.

This is a great type of home equity for homeowners who do not want to take a lumpsum amount of loan.

While the interest rates are not fixed, the interest payments on this type of home equity loan can be lower than fixed-rate home equity loans as homeowners do not receive a lumpsum amount and do not have to pay interest on money that won’t use.

How does it work?

Obtaining

Homeowners wanting to acquire home equity loans must carefully consider their options when it comes to the lenders providing the loans. Different lenders will have different costs and rates associated with their loans.

These lenders will also have different credit rating requirements that borrowers, the homeowners must meet.

The amount of loan provided and the interest rate are determined after the credit rating of the borrower and the risks to the lender is established.

Lenders may also do other extensive checks on the borrowers to determine whether a loan should be provided to them or not.

Furthermore, lenders will also require an appraisal of the home being offered as collateral to determine the fair value of the home in the market as it will determine the amount of loan that can be offered.

Lenders usually ensure that the amount of loan provided to homeowners does not exceed 80% or 90% of their home’s fair value.  An estimate of a home’s worth can be determined by using online tools.

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However, this estimate can be used only for personal use and not acceptable to the lenders. A more accurate fair value of a home can be provided by local real estate agents.

Loan To Value Ratio

The loan to value ratio is a ratio of the loan that is being provided and the value of the asset that is being acquired.

In the context of home equity loans, the loan to value ratio is used by lenders to determine the amount of loan that should be provided to the homeowners based on the value of their homes. This value, as mentioned above, is generally kept between 80% and 90%.

For example, a home is worth $250,000 and the remaining mortgage on the home is $150,000.

If the homeowner wants to acquire a home equity loan, the amount of loan provided is determined using the loan to value ratio.

Assuming the lender limits the loan to 80% of the home’s fair value, the total loan that will be provided to the homeowner is $50,000.

This is calculated by taking 80% of the value of the house ($250,000 x 80% = $200,000) and reducing any remaining mortgage payments (i.e. $150,000) from it.

Payments

Once a loan is provided to the homeowners, they will be required to pay regular interest and principal repayments to the lenders.

In case of fixed-rate home equity loans, the total amount of payment is fixed and pre-determined.

For home equity line of credit loans, these payments are variable and are calculated every time a payment is made.

This is calculated based on the amount that the borrower has currently borrowed and the interest rate prevalent in the market.

In case of default in the payments, the home offered as collateral may be sold to meet the required payments to the lender.

Benefits and Drawbacks

Home equity loans can have many benefits for both lenders and homeowners. However, they may also come with a set of drawbacks for both parties.

The main benefit of the home equity loan for homeowners and lenders is that a collateral is provided in the form of the home.

This benefits the lenders to reduce their risks associated with lending money as in the case of default, the home can be sold to compensate the lender.

Since the risks of the lenders are reduced, it allows lenders to offer the homeowners lower interest rates, thus, benefiting them as well.

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This can even put home equity loans as a better alternative for debt as compared to other sources of debt such as credit cards, etc. that require a higher interest rate.

There is a potential drawback for homeowners getting home equity loan as well, as if they fail to repay the loan on time, they may lose their homes.

Another benefit for homeowners that home equity loans provide is that interest payments made under the loan is tax deductible.

This means that any interest payments made for the loan can be used to reduce the tax of the homeowners.

However, for the interest payments to be deductible, it is required that the fund received from the home equity fund only be used for home improvement.

Homeowners can also benefit by taking a home equity loan and using it to consolidate other high-interest loans. This can be very beneficial if it is used to consolidate unsecured loans that demand a high-interest rate.

However, this can also be risky for homeowners as it means they need to pile up on more debt to pay older debts.

Homeowners can use the money received from the loan for house improvements.

This will not only allow them to claim tax deductions, as stated above, but it will also help increase the value of their homes. This can help in securing better future loans.

Home equity loans need to be repaid immediately if homeowners want to sell their homes. As the loan is secured against the home, if the home is sold, the loan has to repaid in its entirety.

The home equity loan drives down a home’s equity as it is also a type of loan on the house as a mortgage.

Conclusion

Home equity loans are loans that can be obtained by homeowners by offering their homes as a collateral.

This collateral makes it easier for homeowners to obtain the loan. There are two types of home equity loans, fixed-rate and line of credit. Homeowners must go through different checks before being granted the loan by lenders.

Lenders decide on the amount of the loan using the loan to value ratio. Once a loan is received, regular payments must be made, or else the homeowner may risk losing their homes.

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