A home equity loan also known as a second mortgage is a type of loan in which the borrower uses the equity in their home as collateral. The loan amount is determined by the value of the property, and the amount of equity the borrower has in the home. The equity in a home is the difference between the value of the property and the outstanding mortgages or liens on the property. Home equity loans can be used for a variety of purposes, such as consolidating high-interest debt, making home improvements, paying for education expenses, or even financing a vacation.
How does a home equity loan work?
A home equity loan works by allowing the borrower to borrow against the equity in their home. The lender will determine the value of the property and the amount of equity the borrower has in the home. The borrower can then borrow up to a certain percentage of that equity, with the loan being secured by the home. The borrower will make monthly payments on the loan, with interest, until the loan is paid off.
The lender determines the amount that a homeowner is allowed to borrow partially by calculating the loan-to-value (LTV) ratio. The LTV ratio is calculated by dividing the outstanding mortgage balance by the value of the property using the following formula:
Current loan balance ÷ Current appraised value = LTV
For example, if a home is worth $300,000 and the outstanding mortgage balance is $200,000, the LTV ratio would be 67% ($200,000/$300,000).
Lenders typically have a maximum LTV ratio that they will allow for a home equity loan, usually around 80-90%. This means that a borrower can borrow up to a certain percentage of their home equity, depending on the lender’s guidelines. For example, if a borrower has $100,000 in equity in their home and the lender will allow an LTV ratio of 80%, the borrower could borrow $80,000. They would then make monthly payments on the loan until it is paid off, with interest added to the loan balance.
It’s important to note that a high LTV ratio can make it more difficult to qualify for a home equity loan and may result in a higher interest rate. It also increases the risk of the lender, as they will be lending a higher percentage of the home’s value, so they might require additional documentation or credit score.
How to calculate your available equity
To calculate your available equity, you will need to take the value of your home and subtract any outstanding mortgages or liens on the property. The resulting number is your available equity.
The formula for calculating available equity is:
Current Appraised Value – Mortgage Balance = Home Equity
For example, if your home is valued at $300,000 and you have a mortgage balance of $200,000, your available equity would be $100,000.
It’s important to note that the value of your home is not always equal to the purchase price, it’s determined by an appraiser and can vary depending on the market conditions and the condition of the property. It’s also important to consider any outstanding mortgage balances, as well as any liens or other debts that may be attached to the property.
Advantages of a home equity loan
- A home equity loan allows you to borrow against the equity in your home, which can provide a larger loan amount than other types of loans.
- A home equity loan can be a good option for consolidating high-interest debt or making home improvements.
- May be tax-deductible (see below for details)
Disadvantages of a home equity loan
- A home equity loan puts your home at risk if you default on the loan.
- The loan term is usually shorter than a first mortgage.
- Interest rate can be higher than first mortgage
Home equity loans and tax-deduction
Home equity loans became popular after the Tax Reform Act of 1986, as they provided a way for consumers to bypass the elimination of deductions for the interest on consumer purchases provision.
However, the Tax Cuts and Jobs Act of 2017 suspended the deduction for interest paid on home equity loans and HELOCs until 2026, unless the loan is used to buy, build or substantially improve the taxpayer’s home that secures the loan. This means that the interest on a home equity loan used to consolidate debts or pay for a child’s college expenses is not tax deductible.
Difference between home equity loans and home equity line of credit (HELOC)
A home equity loan is a lump sum loan, while a home equity line of credit (HELOC) is a line of credit that you can borrow against as needed. A home equity loan has a fixed interest rate and a set repayment term, while a HELOC has a variable interest rate and a draw period during which you can borrow funds, followed by a repayment period.
Difference between a home equity loan and refinancing
A home equity loan is a second mortgage, while refinancing is the process of replacing your first mortgage with a new loan. A home equity loan allows you to borrow against the equity in your home, while refinancing allows you to replace your existing mortgage with a new loan that may have a lower interest rate or different terms.
How to qualify for a home equity loan
To qualify for a home equity loan, you will need to have a certain amount of equity in your home and a good credit score. You will also need to provide proof of income and employment, and have a clear title to the property.
How to choose the best home equity loan
When choosing a home equity loan, you should consider the interest rate, fees, and repayment terms. Compare offers from multiple lenders and choose the loan that best meets your needs. Be sure to read the fine print and understand all of the terms and conditions before accepting a loan.
FAQs
Will taking out a home equity loan hurt my credit score?
Taking out a home equity loan will likely have a small impact on your credit score, as it is a new loan the lender will perform a hard credit inquiry that will be added to your credit report. However, if you make your payments on time and keep your credit balances low, your credit score should not be significantly affected.
What should I look for when applying for a home equity loan?
When applying for a home equity loan, you should look for a low interest rate, minimal fees, and a repayment term that fits your budget. It’s also important to consider the lender’s reputation and customer service, as well as the loan’s terms and conditions. Be sure to carefully read and understand all of the fine print before accepting a loan.
Is it good to borrow from home equity?
Borrowing from home equity can be a good option if you need to consolidate high-interest debt, make home improvements, or pay for other expenses. However, it is important to keep in mind that a home equity loan puts your home at risk if you default on the loan. It is important to consider all of your options and make sure that you can afford the payments before taking out a home equity loan.
How long do you have to pay back a home equity loan?
The repayment term for a home equity loan can vary depending on the lender and the loan terms. Typically, home equity loans have a repayment term of 5-15 years.
Can you take equity out of your house without refinancing?
Yes, you can take equity out of your house without refinancing through a home equity loan or home equity line of credit (HELOC). These types of loans allow you to borrow against the equity in your home without having to refinance your first mortgage.
What credit score is needed for a home equity loan?
The credit score needed for a home equity loan can vary depending on the lender and the loan terms. Typically, a credit score of 620 or higher is needed to qualify for a home equity loan. However, some lenders may require a higher credit score or may have other requirements for qualification.
