How Does A Home Equity Loan Work

As the name suggests, a home equity loan is based on how much equity a person has in their current property. Homeowners can put up their own property as collateral in order to borrow more money from the bank. The maximum limit of these home loans is defined based on how much equity an individual has in their property, and also the market value of that property.

Let’s say the market value of a homeowner’s property comes out to be $100,000, and they have 70% ownership in that property, the equity will be calculated at $70,000. These loans were quite famous during the early 90s as they allowed borrowers to deduct interest from their tax returns. However, the home equity loan lost popularity when a legislation was passed in December 2017 which removed tax deductions based on home equity loans.

Since a home equity loan is secured against the applicant, the interest rate is expected to be lower than other personal financing facilities. If you need cash to renovate your loan, rather than applying for a personal loan, you can put up your home as collateral and borrow money from the bank at a much cheaper rate using this facility.

Why Home Equity Loan is also referred to as Second Mortgage

The home equity loan is sometimes referred to as a second mortgage. There is a genuine reason behind this second name for a home equity loan. When you take up a mortgage on a house, the loan tenure can go up to 20 years. During that time, the property that you took a mortgage on may appreciate in value, while the mortgage loan you took a couple of years back remains the same. This means that you have more equity in your house than your current mortgage. A borrower can use this extra equity in the house as collateral to acquire more cash from the bank. This is the sole reason why Home Equity Loan is also referred to as Second Mortgage.

How does Home Equity Loan Work

If you are eligible for a Home Equity Loan, the bank will assess the value of your equity in the property. Based on this assessment, they will disburse a lump sum amount which can range anywhere between 80% to 85% of the ownership value. There are two ways in which borrower can pay interest on a home equity loan.

Fixed Rate Term – In this type of Home Equity Loan, a lump sum payment is transferred into the borrower’s Home Equity Loan account. Once they acquire the money, they can use it for whatever reason they want. If they use the Home Equity Loan for renovation purposes, they may be able to deduct the expense from their tax returns as well. Since this is a fixed rate term loan, an equal amount of interest is charged to the borrowers account every month.

The line of Credit – Home Equity Loan line of credit is used when the borrower does not want to use up all the loan immediately or in the near future. The line of Credit is just like a credit card except that it is secured against personal property and the interest rate is quite low. Interest charged on such types of Home Equity Loan may vary each month based on the borrower’s utilization rate. If a borrower is provided a credit limit of $100,000, and they were able to utilize only 20% of the total amount at month end, then interest will be charged on $20,000 only.

Benefits of acquiring a Home Equity Loan

A Home Equity Loan offers multiple benefits to borrowers. Some of the significant advantages of taking up a home equity loan are mentioned below:

Consolidation

If a borrower is using multiple financing facilities like personal loans, and credit cards. They may be able to consolidate all these credit facilities into a single Home Equity Loan. This will provide two-fold benefits to such individuals. Firstly, they will be able to combine all the loans into a single loan, and secondly, they will have to pay a lower interest rate on their new financing facility, since it will be secured against their home equity.

Higher Approval Rate

Home Equity Loans usually have a higher approval rate than a regular mortgage. The major reason for this high approval rate is that a Home Equity Loan is secured finance facility. Banks can minimize their risk by keeping the applicant’s property as collateral in case the borrower defaults on the loan.

Larger Amounts

Borrowers can gain access to a larger loan amount using this financing facility. Considering that an average application may have at least 25% ownership on a real estate property, the disbursed amount will be quite high when compared to a credit card.

Helps in paying-off large expenses

Home Equity Loan is a great way to manage your ticket expenses. If your kid wants to apply to college, a home equity loan may be a great way to pay out their first year’s tuition. If you want to start up a new business, you can use this loan to finance your seed capital.

Pitfalls in a Home Equity Loan

One of the major downsides of acquiring a Home Equity Loan is that it may provide you with higher credit than you actually need. Although nobody regrets having some extra cash in their hands, irresponsible use of a Home Equity Loan can put you in more debt than you were in before. With interest mounting on your Home Equity Loan, the Debt to Equity ratio may increase more than 100% increasing your risk level as a borrower. This may trigger the lender to increase your interest rate to mitigate that risk.

Home Equity Loan is a great way to borrow an extra sum of money from a bank at a relatively lower rate. However, before applying for this facility, applicants should have a clear goal in mind that they want to achieve by acquiring this facility. If utilized properly, a Home Equity Loan can be a great way to minimize your debt burden and achieve your future financial goals.