Understanding Home Equity Loans
What is a Home Equity Loan?
A home equity loan allows you to secure a line of credit against the total value of your home. You’re basically using your home as security, and if you own a home (even if it’s mortgaged rather than owned outright), these loans can help you secure a larger amount of loan money while meeting fewer stringent qualifications than other types of high value loans.
It’s essentially a type of “second mortgage.” To get one, you’ll need to have built up enough equity in your home.
Understanding Home Equity
Home equity is your interest in your home, as a homeowner. It’s a number that increases over time if the home’s market value goes up, or you’ve paid down the balance of your initial mortgage loan.
Your home equity is the “part” of your home that you truly “own,” from a bank’s perspective. If you bought a house with a 20% down payment, your home equity interest will be 20% of the home’s total value.
While you “own” 20% of the house, the bank doesn’t technically “own” the other 80%. Instead, it’s basically being used as collateral for your mortgage loan, and you own it de facto.
As we’ve mentioned, increases in your home’s value can raise your home equity. So if you bought a house for $200,000 with a $40,000 down payment, and the house is now worth $350,000, your stake will be 20% of that value, or $70,000.
Building Up Your Home Equity
There are some actions you can take, as a homeowner, to raise your home equity, giving you access to a larger loan amount if you take out a home equity loan in the future. Some things you can do include:
- Paying back loans. As you pay down the loan value of your mortgage, your home equity goes up.
- Increasing the value of your home. This is often one of those things you might not have full control over. It can depend on the broader housing market, the neighborhood around you, and other factors. However, some kinds of home improvements may help to increase a home’s market value, and could be worth investing in for this reason. For example, if a $5,000 investment in repairs and renovations could raise your home’s value by $10,000, it might be worth the investment.
- Keeping up with routine maintenance. This might seem obvious, but it’s often easy to neglect. It can be a big factor in making sure your home’s value is the maximum it could be.
- Paying monthly loan payments. Most mortgages are “standard amortizing loans,” which means that over time, more of your monthly payment will go toward the principal, and less toward the interest you’ve accrued over time. The more time passes, the more of the debt you’ll pay off, because the loan is structured to make sure you are able to pay off the principal as well as the interest.
- Choose a shorter term mortgage, if possible. Mortgages come with different time increments, including 15-year, 30-year, and others. If your primary goal is to build equity in the home, you can speed up that process by going with the shorter term instead.
Types of Home Equity Loans
There are two main kinds of home equity loans that are available for homeowners. It’s easy to qualify as long as you own real estate, and the interest is often relatively low. However, while there are benefits, there are also possible risks, and home equity loans may not be the best choice in every situation.
- A lump sum home equity loan. A typical home equity loan involves a lump sum issued to the borrower. You can get it all at once — making it available for whatever you need it for — and then pay it back with monthly installments over anywhere from five to fifteen years. Some of the things you can use the lump sum of money for can include financing home renovations that will provide an ROI by boosting your home’s value significantly; consolidating and paying off higher-interest debts like credit card debt; or even going on vacation. It’s your money, and you’re free to use it however you wish — though you should be careful that you’re using it wisely.
- A home equity line of credit (HELOC). Instead of one lump sum, a HELOC structure allows you to pull out funds in different increments as you need them. You only need to pay interest on what you actually borrow. As long as the line of credit stays open, you can withdraw as you need, like you might with a credit card. People often use this loan structure to cover expenses that are drawn out over a period of time, like paying for a child’s college tuition, or staying stable financially during temporary unemployment.
What Can I Do with Home Equity?
There are several common uses for home equity among homeowners. This could involve taking out large lump sums to have cash on hand, or leaving it instead so you can pass on that wealth to your children. It generally depends on your own specific lifetime financial goals.
A home equity loan can help you:
- Fund the purchase of your next home. You may not want to stay in your current home forever. Eventually, you might want more square footage to accommodate a growing family, or you may need to relocate for a job. When you have more home equity, and have more of your mortgage paid off, you’ll get more money from the home sale to put toward your next house.
- Borrow against the equity when you need money. Home equity loans can give you cash you can use for just about anything you need it for. It’s not the best idea to use this money to pay off basic expenses — if you’re struggling to pay your bills on time, there are other things you can do that will be more helpful in the long run.
- Use a reverse mortgage to fund your retirement. Reverse mortgages are a special kind of loan that provides additional monthly income for retirees. They are relatively complex, so you should talk with a financial advisor or estate lawyer before making the decision to take a reverse mortgage.
What are the Risks?
We’ve mentioned that for homeowners, a home equity loan can be an easy way to get cash fast. So what’s the catch?
The biggest risk with a home equity loan, is that your home is used as the collateral. That means that if you are unable to pay it back, your home could be foreclosed upon — at which point the lender will sell it off themselves, to recoup the loss they took when you didn’t pay back your loan.
Foreclosure is something no one should have to go through. It’s a very real risk if you’re not careful with home equity loans. For that reason, it’s recommended that you only take out a home equity loan if you feel confident in your ability to pay it back.
If You Need Money, a Home Equity Loan Might Be a Good Choice
In some cases, a home equity loan could be your best option if you need cash on hand, and have built a significant amount of equity in your current home. It’s not without its risks, so it’s important to understand how these loans work, and to make sure you’re using it for something that you won’t regret later. Read more articles on loans, credit scores, and financial advice on the TNL Car Title Loans blog.