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What is a Home Equity Loan?

By Arvin Sahakian · Jun 12, 2015 · Mortgage

What is a Home Equity Loan?

Image courtesy of Flickr, U.S.D.A.

A home equity loan can help you with home repairs, improvements or to consolidate credit card debt. Learn more about this type of loan to decide if it's right for you.

Unlike other types of loans, a home equity loan allows you to tap into the equity (value) of your home. Many homeowners take advantage of this type of loan to pay for large home improvement tasks, unexpected repairs, or to take care of other credit debts that have a higher interest rate.

These loans are not always the perfect solution. It is important that you understand the basics of this loan type before you choose to open one of these credit lines.

Home Equity Loan Definition

An equity loan is secured by your home and allows you to borrow from the equity in your home without having to refinance your existing first mortgage or taking out a new first mortgage if your home is already paid off.

Types of Home Equity Loans

There are two basic types of home equity loans. Each may be useful for different homeowners with different financial needs.

1. Fixed-Rate Loan

Fixed-rate home equity loans offer a lump sum payment to you. The loan has a set interest rate and repayment term that remains the same throughout the life of the loan. You will have to make monthly payments based on the entire lump sum issued to you.

2. Home Equity Line of Credit (HELOC)

A HELOC (home equity line of credit) is a variable-rate loan. Rather than offering a lump sum, this option works more like a credit card. You will be pre-approved at a spending limit and you can withdraw money from the account as needed.

The interest rate may fluctuate and the monthly payment will vary depending on how much is borrowed at any given time. If there is a term limit set, the loan must be repaid at the end of this term.

Credit Requirements

Before the recession in 2008, it was much easier for homeowners to qualify for a home equity loan. However, underwriting requirements for these loan types have become more difficult in the days since.

The main requirement is that you have enough equity in the home. Beyond that, credit requirements vary from lender to lender. A small number of lenders may accept a minimum of a 620 credit score while other lenders may require 680 or higher.

Document Requirements

In many ways, getting a home equity loan is a lot like a mortgage, where you will have to provide similar documentation. In addition to providing proof of homeownership and equity, you will need to provide:

  • Paystubs
  • Tax Returns
  • Bank Statements
  • Proof of Identity

Different lenders may have more detailed requirements for you to submit-depending on the size of the loan and the credit situation.

How do Home Equity Loans Work?

Once you qualify for the loan, you are either issued a check or bank draft (for a fixed-rate loan) or a method of accessing your credit line (for a home equity line of credit). You will have access to the money to pay your bills, pursue renovations or otherwise utilize the equity cash as needed. You will have a repayment term set and each payment will reduce your loan balance and cover some of your interest costs.

An Example of a Home Equity Loan:

  • You need $25,000 to complete repairs to your kitchen.
  • Your home's value is $300,000 and you owe $150,000 on your first mortgage.
  • You have $150,000 of equity to borrow the $25,000 you need.
  • You apply and are approved for a 25-year home equity loan at a 7.5% interest rate.
  • Your monthly payment would be $185 per month for the life of the loan.
  • This payment will be in addition to your existing first mortgage payment.

How Can Home Equity Loans Be Used?

While a home equity loan can be used for nearly anything, some of the most common uses include:

  • Home Repairs
  • Renovations or Improvements
  • Dealing with Tax Issues
  • Purchasing Investment Property
  • Consolidating Smaller Loans

Are There Any Disadvantages to Home Equity Loans?

The main disadvantage of a home equity loan or line of credit is that when you do not research properly, it is easy to get caught in a difficult financial situation.

Sometimes these loans can have a high interest rate, making them a poor choice for paying off low-interest loans. Additionally, if you just need to borrow a small amount, it may be difficult to find a lender willing to work with you.

Be Sure it Makes Financial Sense

Home equity loans are a useful tool for an educated consumer. Many home owners choose to get these separate home equity loans because they already have a low rate first mortgage they have been paying on for many years, so it makes financial sense to not refinance the entire loan.

Before deciding to borrow, it is important that you spend some time researching the options available to you. By doing this, you will avoid getting in over your head and will find the perfect solution for your borrowing needs.

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