What is a Home Equity Loan/How Do They Work?

For those that were either fortunate enough to buy a home during the downturn of the housing market, or have built up enough equity after paying down the mortgage for a number of years, it may be time to pull out funds and put your hard-earned money to good use. Whether it’s paying off debt or funding a wedding, taking out a home equity loan can be the answer for those needing a little extra boost to the finances. Here is a look at what exactly a home equity loan is and how they work after the loan process is complete.

How Much Can I borrow?

Little by little each month you slowly chip away at the mortgage balance with each payment, building up equity. Instead of refinancing the mortgage for cash out or putting a large purchase on a credit card, homeowners look at a home equity loan as a way to have access to funds to pay for an expense that is not currently set aside in an emergency fund. Lenders typically will allow you to borrow up to 80% of your home’s value, so by subtracting what your current mortgage balance is, you can figure the loan-to-value. If your home is worth $250,000 and you owe $125,000, your loan-to-value is 50% and you would be able to borrow up to 30% more or $75,000.

What Makes this Different from a HELOC?

While the loan-to-value ratio is still capped at the same limit, the major difference between this and a line of credit is that this follows in line with a typical mortgage in that it’s for a set amount and terms. With a HELOC, it works more like a credit card where you are approved for a certain amount and can borrow within that range, only paying back what you draw. Also, with a home equity loan the rates are fixed, where as a HELOC they can increase as the market fluctuates.

Any Qualifying Stipulations?

The amount of equity has a factor in your approval, as the lower the LTV, the more you have vested into the property, and the more the lender can be guaranteed to be paid back if you were to default on the loan. Since this loan is in second position, the first lienholder would have first dibs on the sale of the home, so the 2nd lender will want to ensure the recoup as well.

In addition to equity, credit score is a key factor to take advantage to the most favorable interest rates on the market. Beyond credit, income, assets, and even an appraisal may be necessary to grant your approval. The great factor about either a home equity loan or line of credit is that the use for the proceeds is not a deciding factor in approval, as many use for debt consolidation, a home improvement, wedding, or even to take a much-needed vacation. No matter the use, before you proceed with an application, you’ll want to ensure this product not only fits your needs, but also the household budget.

This article does not necessarily reflect the opinions of the editors or management of EconoTimes.