Home Equity Loans: What is it? And How Does It Work?

What is a Home Equity Loan?

A home equity loan can be defined as a type of consumer debt. It is also referred to as an equity loan or a home equity installment loan.

As a matter of fact, this particular loan gives homeowners the ability to borrow in return for equity in their property.

In this case, the loan amount is mainly based on the existing difference between the currently prevalent value of the property, and the outstanding mortgage value.

There are two main types of home equity loans. They include fixed-rate loans, and home equity lines of credit (shortened to HELOCs).

Speaking of fixed-rate loans, it can be seen that they provide one lump sum amount against the loan, whereas on the other hand, HELOCs mainly offer borrowers resolving lines of credit.

Home Equity Loan can be defined as the value of the property owner’s interest in the given property. It can be seen that the property owner can be able to leverage the equity he holds in the given property in the form of collateral, in the case where he needs to obtain a home equity loan.

This can either be a traditional home equity loan, or a fixed-rate home equity line of credit.  Home Equity Loans are required are also referred to as second mortgages.

This usually permits owners to borrow a given lump sum amount against the existing property for a fixed rate over a given period of time. In this aspect, numerous home equity loans are used to finance large expenditures that might include property repairs.

How Does a Home Equity Loan work?

A home equity loan is basically a mortgage. In this case, the collateral that is offer is a certain share in equity in the property which is owned by the borrower.

This acts as a security for the lender because he needs to have certain security before he is able to extend the loan. However, there are certain technical aspects that need to be considered in this regard.

Firstly, it can be seen that the homeowner is allowed to borrow an amount that is partially based on the combined loan to value ratio.

The CLV ratio is allowed to lie between 80 to 90% of the property’s appraised value. In the same manner, it should also be noted that the amount of loan, and the interest that is charged is subject to the borrowers’ credit score, as well as payment history.

These features are highly important in determining the overall amount extended, as well as the relevant interest rate charged.

In the case of traditional home equity loans, it can be seen that they have a certain repayment term. This is similar to that of conventional mortgages.

This means, that fixed payments that cover both principal and interest need to be covered in this regard.

However, it must be noted that in cases where the borrower is unable to pay back the amount he has borrowed, the house (kept as a collateral) could be sold off in order to satisfy the remaining amount of the debt.

The most common usage and relevance of home equity loan arises in situations where owners decide to carry out some renovations in order to increase the value of the house.

In this scenario, it can be seen that the equity that the owners have managed to build in the house can then be converted into cash, and can render higher financial benefits as compared to the stand-alone value of the house, without any renovations.

However, there is an inherent risk factor that needs to be taken into account in this aspect.

In the case where the value of the house declines, because of any given reason, the strategy mentioned above might backfire, since the borrower would end up owing more than the amount borrowed, in terms of the decline in value.

See also  Interest on Debentures: Accounting and Journal Entries

In the same manner, it should also be taken into account that in the case where owners want to relocate, and there is a decline in value, their calculations would be disrupted because of which they might not be able to move forward with their relocation arrangements.

Home Equity Loans might need to be refinanced, because for a number of reasons. It might be because of the fact that there are better alternates, or loan terms need to be revised in lieu of any unprecedented circumstances.

In this case, it can be seen that companies have an option to either go for a cash-out refinance. A cash-out refinance of the property can be a good manner to refinance a home equity loan.

Difference between Home Equity and Mortgage

Regardless of the fact that home equity and mortgages and home equity are both similar in the sense that both of them pledge properties as collaterals, yet there are a couple of differences.

Firstly, in the case of home equity loans, it can be seen that in a traditional mortgage, home equity loan is withdrawn after there is ownership in the property.

On the other hand, mortgage is utilized when a property is purchased. Equity starts building over the course of time, as the amount is settled.

The allowed amount on mortgage is usually up to 80% of the property’s value. On the other hand, the amount that can be borrowed via mortgage is variable, and mainly depends on the percentage of ownership within the property.

Example of Home Equity

Let’s assume that a property owner purchases a property for $100,000, with a 20% down payment. He covers the remaining $80,000 with a mortgage. The property owner has equity of $20,000 in the property.

In the case where the value of the property remains the same over a period of 2 years, and an amount of $5,000 is applied to the principal, the property owner is going to have an amount of $25,000 in home equity when the two year period ends.

However, if the market value of the house increased by $100,000 over the two years, and a similar amount of mortgage payment is applied to the principal, the owner is likely to have home equity of $125,000.

Therefore, it can be seen that the inherent risk with Home Equity Loans is the fact that they are subject to fluctuation depending on the value of the property. In the case where the value of property increases, it positively impacts the borrower.

However, where property value decreases, the repayment amount of the borrower increases. This is because of the reason that the underlying collateral against which the loan has been secured has fallen down in value.

Types of Home Equity Loans

As mentioned earlier, it can be seen that there are two main types of home equity loans, which are defined as Fixed Rate Loans, and Home Equity Lines of Credit (HELOC). Both of these types are explained in detail below.

Fixed-Rate Loans: As far as Fixed Rate Loans are concerned, it can be seen that they mainly comprise a single lump-sum payment, which is extended to the borrower.

This amount is arranged to be repaid to the lender, over a period that usually varies between 5 and 15 years.

The interest rate is agreed upon in the initial stages. Across the course of the loan period, it can be seen that payment routine, installment amounts, as well as interest rates tend to remain the same.

However, in the case where the home is sold before the period ends, the loan is supposed to be repaid in full.

See also  Strategic Alliance: Definition, Types, Importance, and Disadvantages

Home Equity Lines of Credit (HELOC):  As compared to Fixed Rate Loans, it can be seen that HELOC can be termed as a revolving line of credit.

This means that borrowers have an option to draw the amount they require, and then payback. He can then draw again, and repeat these iterations as long as the borrower stays within the allowed limits.

In this case, it can be seen that the withdrawals can only be made for the time period for which a home equity loan has been extended. In most cases, this time duration tends to vary between periods of 5 to 10 years.

Furthermore, Home Equity Loans also tend to carry a variable rate of interest. However, in some of these instruments, lenders also prefer to convert back to a fixed amount after a certain period of time.

Advantages and Disadvantages of Home Equity Loans:

Home Equity Loans have considerably increased in popularity over the course of time, predominantly because of how they are structured, and how they managed to facilitate those who are looking forward to converting their home equity to cash.

However, both pros and cons need to be evaluated in order to get a better idea regarding the viability of Home Equity Loans.

Speaking of the advantages of Home Equity Loans, it can be seen that they are relatively easier to obtain.

They can be regarded as a relatively easy source of cash, and therefore, they can be regarded as a really viable tool for those who are actively looking for funds to borrow.

Therefore, in the case where buyers have relatively stabilized income levels, and have certainty about their ability to repay the loan, Home Equity Loans tends to be a favorable choice in this regard.

Furthermore, it can also be seen that it offers relatively lower interest rates, because of which it is often a favorable choice in terms of lower financial charges associated with Home Equity Loans.

In the same manner, it also offers tax deductibility, which is an added incentive in this regard.

Home Equity Loans also prove to be a better choice for borrowers because of the fact that it is a secured debt. In this aspect, the lender is supposed to run a credit check, in order to assess the inherent creditworthiness and the existing loan-to-value ratio.

The reason as to why Home Equity Loans are cheaper is because of the fact that they are cheaper as compared to credit card payments.

However, this is mainly applicable in cases where there is proper clarity regarding the amount that is intended to be borrowed, in addition to the fact that the purpose of the loan is also clarified and straightened out.

Regardless of the relative ease of home equity loans, in addition to the advantages they hold for the consumers, it can be seen that there are a number of pitfalls that need to be considered in order to get a clear picture regarding home equity loans and their overall viability.

Firstly it can be seen that home equity loans, often end up putting people in a debt cycle. This means that they are often trapped in a perpetual cycle of spending, because of which they continue to sink deeper and deeper into debt.

In other words, it promotes excessive spending in the sense that people end up taking up loans, in order to pay off their existing debt, and therefore, this trend continues.

This strategy, referred to as reloading, often disturbs the cycle, and causes trouble when consumers need to withdraw higher loans in the future.

This is a drawback of home equity loans, that because of the relative ease with which it can be obtained, it might not always be used for the best avenues.  

See also  Crossover Rate: What Is It and How To Calculate It?

Important Considerations Regarding Home Equity Loans

There are a number of aspects that should be considered when applying for, or signing on a home equity loan. These considerations are mentioned below:

  • First of all, it is highly important to compare interest rates and the terms that are offered within the agreement. This means that there is an underlying need to compare the given terms and conditions with other players in the market so that a better decision can be made on the option that needs to be pursued in this regard.
  • In the same manner, when this loan has to be pursued, it is imperative that multiple options should be considered when considering Home Equity Loans. Therefore, the choice should not always be limited to banks. Instead, borrowers should also look into considering other options like credit unions. The main advantage they might offer is that they often offer better interest rates and higher personalized account services.
  • It is also important to have a proper understanding of the credit rating and creditworthiness of an individual. This is highly important because it helps to develop an understanding regarding how much they should borrow, and how it is going to impact their credit rating.
  • It should also be noted that whilst Home Equity Loans are tax-deductible, yet they are only tax-deductible in the cases where the loan is utilized to purchase or improve the property against which the loan is taken.

What to Avoid during Home Equity Loans?

There is a need to take care of certain aspects that are important when it comes to home equity loans.  These are aspects that need to be considered in order to save themselves from financial losses.

These key points need to be included in the overall home equity systems that need to be fulfilled. They are as follows:

  • Loan Flipping: Reloading, as mentioned earlier, can be detrimental to the overall profile in the case where it stacks up debts, and creates a debt trap for the borrower.
  • Insurance Packing: Excessive, or frequent Home Equity Loans can also result in credit insurance being mitigated, or adversely impacted.
  • Bait and Switch: In the case of home equity loans, the lender often offers more than one set of loan terms when applied for. Therefore, they are then pressured to accept higher charges as a result of choosing either of the options.
  • Equity Stripping: The terms that are put forth by lenders are mostly based on the equity in the respective, and not the ability of the borrower to repay. Therefore, in the case where the borrower is unable to pay back the amount, he ends up losing his house.

Conclusion

Therefore, it can be seen that Home Equity Loans can be termed as an extremely viable resource that can help to arrange a considerable amount of finance, against a percentage of ownership in their houses.

As a result of this, they are able to raise a considerable amount of finance with proper help. Hence, this is a viable alternative for those who are looking to raise money, with a specific objective in mind.

However, before they enter into contracts and agreements of a home equity loan, it is also imperative to consider the advantages and disadvantages.

Given the fact that subjectivity tends to be a very pressing matter when it comes to financial issues, home equity loans might not be the best alternate for everyone.

It is important to take into consideration all these factors, so that a better, and a well-informed decision can be made regarding the viability of the contract in terms of other options that are available. 

Scroll to Top