What is a home equity loan and how does it work?

Key takeaways:

• Using your home as collateral, a home equity loan allows you borrow money to be used any way you wish, but some uses are more advised than others.
• A traditional home equity loan is different from a home equity line of credit (HELOC); get the one that best meets your needs.
• A home equity loan has benefits and drawbacks; we can help you determine if it’s right for you.

Thinking about using a home equity loan to buy an investment property? Need cash to build a garage or renovate your basement? Want to pay for college or pay off high-interest loans but don’t have the funds to do it?

For many of us, our home is the biggest investment we’ll ever make. A home can be a profitable asset; you may make money when you sell, but did you know that you can also access the money you’ve invested in your home along the way? Home equity is the difference between the current market value of your home and how much you owe on it. Rather than wait until you sell the house to access that money, there’s a way you can take advantage of that equity and put that money to work for you now using a home equity loan.

What is a home equity loan?

Most loans require collateral as security, and a home equity loan uses your home’s equity as that collateral. As your home increases in value, and as you pay down your mortgage, you gain equity. You can borrow against that equity and access that money without having to sell your home.

Home equity loans often have low-interest rates and favorable terms, and the interest you pay may be tax-deductible in certain circumstances. When you take out a home equity loan, you can use the money any way you wish; some of the most common uses are for a remodel, paying for college, or paying off high-interest loans. You could even use the money to buy another property.

However, all these advantages come with a serious consideration: if you fail to make payments under the terms of the loan, the lender can foreclose, and you would lose your home.

Home equity loans vs. home equity lines of credit (HELOCs)

There are two types of home equity loans:

• A traditional home equity loan has a fixed interest rate and payment terms. It is structured so that the entire loan amount is paid to you in a lump sum, then you make your loan payments in regular monthly installments over the term, which can be anywhere from one to 30 years.
• A home equity line of credit (HELOC) typically has a variable rate of interest. This loan works like a credit card with a pre-established line of credit. You can borrow against the approved amount and withdraw money as you need it, then pay it back over time. The amount of your monthly loan payment varies according to the amount you’ve borrowed along the way.

Deciding which type of loan is best for you depends on how you need to use the money. If you’re purchasing another property, you’ll likely need the lump sum you can get with a home equity loan. If you are doing a remodel, a home equity line of credit might work better, because it allows you to withdraw money only as needed, to pay your contractor as work progresses. Some people even apply for and qualify for a home equity line of credit, and then only draw on it as a just-in-case emergency fund.

How a home equity loan works

With either a home equity loan or a home equity line of credit, the amount you can borrow depends on several factors, including the equity you have in your home, your credit score, your income, and other outstanding debt.

To calculate equity, you’ll need to know two things:

• Fair market value of your home: Determining this can be tricky since it depends on things like your neighborhood, your home’s size and condition, and other factors. You can use an online service like Zillow to get an approximate value, or you can consult a local realtor, but know that your home equity lender will have the final say regarding value. Some lenders may even have an appraisal done, while others use sources like county assessments.
• Amount owed on your home: This is the amount remaining on your mortgage plus other debts that use your home as collateral.

Once you have these two numbers, you can calculate your loan-to-value (LTV) ratio.

For example:

$500,000 fair market value of the home
$300,000 remaining mortgage
Equity = $200,000; you have 40% equity in the home
Loan-to-value (LTV) ratio is 300 (total amount owed)/500 (market value) = 60%

While every lender is different, many limit the loan-to-value (LTV) ratio to 80%. In our example above, this would allow you to take out a $100,000 home equity loan:

$500,000 fair market value of the home
$300,000 remaining mortgage
$100,000 home equity loan
Remaining equity = $100,000; you now have 20% equity in the home
Loan-to-value (LTV) ratio is 400 (total amount owed)/500 (market value) = 80%

Pros and cons of a home equity loan

There are advantages and drawbacks to taking out a home equity loan.

Advantages

• When used well, money from a home equity loan can act as an investment of sorts. For example, if you use the money to do a value-added renovation project, you increase the value of your home, which helps to increase your overall equity.
• Both a home equity loan and a home equity line of credit usually have a relatively low-interest rate and low fees, typically much lower than a personal loan or credit card debt.
• The interest you pay may be tax deductible if the debt is within limits and the money is used to ‘buy, build or substantially improve’ the same home that is securing the loan. Tax laws change, though, so always consult a tax professional.
• A home equity loan has fixed monthly payments that you can count on over time while your monthly payments for a HELOC vary according to how much you’ve borrowed.
• A HELOC is flexible; while you are pre-approved to a certain amount, you only take the money you need when you need it, and you pay the loan down as you go.

Cautions

• One of the biggest risks of a home equity loan is based on the fact that you use your home as collateral. If something happens and you default on the home equity loan, the lender can foreclose, and you would lose your home.
• Think seriously before you decide to take a home equity loan to pay off credit cards. While some people look at a home equity loan as one way to consolidate high-interest debt, it takes a very disciplined borrower to avoid building up that debt again.
• Some home equity lines of credit have a variable interest rate that can go up or down with the market, making the amount of your monthly payment hard to predict.
• Recognize that the value of your home could decline over time; if that happens and you need to sell it, you could owe more money than your home is worth.

Alternatives to home equity loans

As with any financial situation, a home equity loan may or may not be the right choice for you. Here are some alternatives, but all carry their own pros and cons:

1. Personal loan

These loans can be both secured (tied to some form of collateral) or unsecured (when the lender gives you the money based only on your ability to pay). Personal loans usually have higher interest rates and can be more difficult to qualify for.

2. Cash-out refinance

Like a home equity loan, this option allows you to take advantage of your home’s equity but in a different way. Here, you would close out your old mortgage and take out a new mortgage for more than you owed previously, leaving you with extra cash.

When is a home equity loan a good idea? A not-so-good-idea?

Everyone’s financial situation is unique, and what’s good for one person may be a bad fit for another. When considering a home equity loan, here are some things to remember:

• The money from your home equity loan or home equity line of credit can be used to make improvements to the property, which can increase the value of the home and increase the amount of equity you have.
• The interest paid on these loans may be tax deductible if the money is used for improvements to the home that is being used for collateral on the loan.
• Because a home equity loan usually has a lower interest rate than other options such as credit cards or personal loans, you can save on interest by using the money to pay off the other debt. But then you must avoid the temptation to turn around and add more debt.
• Condominiums and mobile homes are not eligible for home equity loans, and rental properties may not qualify for home equity lines of credit.
• Home equity loans are not intended for everyday expenses. And if you’re thinking about using the money for something like a vacation or a wedding, think twice.

How to get a home equity loan

If you think a home equity loan might be the right fit for you, here are your next steps:

• Verify that you meet requirements in terms of credit score, debt-to-income ratio, and ability to repay the loan (being fully employed).
• You’ll need good credit to get the best rates. Check your credit score well before you decide to apply, and fix any errors immediately.
• Apply for a home equity loan online or at your local Global branch.