How Does a Home Equity Loan Work?

Each time you make a monthly mortgage payment, you build home equity and get closer to owning your home debt-free. However, on your journey to paying debt, expenses will come up, and you may not have enough funds in your bank account to cover each one. Home equity can help you in these situations.

You can use the equity in your home to fund renovations or repairs, pay off high-interest debt, cover a costly emergency, or however else you see fit. Home equity loans are one of many ways to tap into your home’s equity, but you should understand how they work before you apply.

These loan products offer many benefits to homeowners. But, unfortunately, there are also some downsides to consider. Understanding the pros and cons of this financial product will help you determine if a home equity loan is right for you.

What is Home Equity?

Home equity is the difference between your home’s current value and your outstanding mortgage balance. Each monthly mortgage payment increases your home equity. For example, if your home is worth $375,000 and you owe $225,000 on your mortgage, you have $150,000 of equity in your home. That doesn’t mean you can borrow $150,000 on a home equity line or line of credit. This number demonstrates how much of the home you own and the percentage you can borrow depends on the lender.

How Does Home Equity Work?

Home equity fluctuates with specific actions you take or when the housing market changes. If you apply for a home equity line of credit (HELOC) or a home equity loan, the lender will look at your credit report, debt-to-income ratio (DTI), and other metrics. Lenders also have loan-to-value ratio (LTV) caps that limit how much you can borrow. Most lenders set this limit at 80% LTV, but some lenders let you borrow enough equity to have a 95% LTV ratio. Lenders consider the combined loan-to-value ratio of your current mortgage and the home equity loan you want to take out.

How Do You Build Home Equity?

Here are a few ways you can build home equity:

• Make a generous down payment. The more money you put down on your home, the lower your loan amount will be, which helps give you instant equity in your home. A higher down payment also makes the monthly mortgage payments more manageable.
• Improve your home. If you make the right improvements to your home, the value could increase and increase your home equity position. Home repairs will also increase your home’s cost basis, which means a lower tax bill when it’s time to sell. Homeowners pay capital gains on the difference between the cost basis and the selling price. Keep track of the investments you make to your home so you can add them to your home’s cost basis.
• Pay off your mortgage faster. You can pay more than the minimum each month or double up on payments to rapidly decrease the principal owed on your mortgage. Many lenders allow homeowners to make principal-only payments to speed up the process. You can pay a 30-year mortgage several years sooner by making more than the minimum monthly payment.
• Stay put. It’s tempting to move around when you grow bored with your home. However, staying put could pay off big if the housing market improves, as your home will likely increase in value and boost your equity. Local factors influence a property’s value over time, but inflation also bodes well for real estate. The limited housing supply creates market dynamics that turn most real estate investments into inflation hedges.

How Much Home Equity Do You Have?

To determine the amount of equity you have, consider getting your home appraised to know how much it’s worth. Also, contact your mortgage company to get the loan payoff amount. Then, deduct this figure from your home’s value to calculate your home’s equity. For example, if an appraiser determines your home is worth $800,000 and you have $300,000 remaining on your mortgage, you have $500,000 in home equity.

What Can You Use Home Equity For?

Many consumers tap into their equity to buy a new home, pay off high-interest debt, fund renovations, pad their nest egg, or purchase a big-ticket item. It essentially acts like a second mortgage and gives the borrower complete flexibility. You do not have to inform the lender about how you intend to use the funds.

Home Equity Loans

Home equity loans are a viable way to access the value of your home. They usually feature lower interest rates than other financial products like personal loans and credit cards.

How Does a Home Equity Loan Work?

A home equity loan is a debt product you can use to borrow between 75 to 80 percent of the equity you have in your home. It’s structured as a fixed installment loan, and you will make equal monthly payments over a period of five to 30 years. Borrowers get to pick the duration of the loan. Shorter loans get you out of debt sooner but have higher monthly payments and tougher requirements. A loan with more years is more favorable for your debt-to-income ratio, which can increase your odds of getting approved. However, you’re stuck with more principal and interest payments if you take out a lengthy loan.

Here are a few examples of how home equity loans work:

Scenario 1:

You purchased your home for $400,000 early last year and made an $80,000 down payment. The housing market has since skyrocketed, and it’s now valued at $455,000. You have only paid $10,000 at this point via mortgage payments and have a $310,000 mortgage balance. Your down payment and mortgage payments increased your home equity to $90,000. Combine that with the $55,000 appreciation, and your total home equity position is $145,000.

After inquiring with a lender about a home equity loan, you qualify for a loan with a combined LTV of 75%. Since your home is worth $455,000 and the combined LTV ratio must stay below 75%, you cannot have a balance greater than $341,250 for your mortgage and home equity loan. Since you have a $310,000 mortgage, you can only borrow up to $31,250 for your home equity loan. You can wait for your home’s price to appreciate more and continue making mortgage payments in the meantime if you want to borrow more than $31,250. You can also work with a lender who has a higher CLTV maximum.

Scenario 2:

Let’s assume that, for this example, the sales price of your home was $250,000 a few years ago, and you currently owe $235,000. Market conditions have improved significantly, and your home is now worth $325,000. You confirm the market value by having an appraisal done, which puts your home equity at $90,000. You find a lender who has a maximum CLTV ratio of 80%. If you take 80% of your home’s appraised value ($325,000 in this example), you discover your maximum balance, which is $260,000. Since you already owe $235,000 on your current mortgage, you can only tap into $25,000 of your home equity.

Some people will be happy with a $25,000 loan, but it won’t be enough for everyone. You can wait for your home to appreciate and for current mortgage payments to strengthen your equity position, but some people need the $25,000 and a little extra now. If you get financing from a mortgage lender with a 95% CLTV maximum, you can borrow more of your home equity. For example, a 95% CLTV for a $325,000 property is $308,750. That’s an additional $48,750 you can borrow against your home. So, while an 80% CLTV lets you borrow $25,000 in this example, a 95% CLTV lets the homeowner borrow up to $73,750 in home equity. This example demonstrates how much the combined loan-to-value ratio impacts the amount of home equity you can tap into for your loan or line of credit.

Benefits of a Home Equity Loan

Here are some key benefits of a home equity loan:

• Fixed interest rate: Some home equity lenders let you use variable rates, but a fixed-rate loan is more predictable. Your monthly payments will stay the same regardless of what happens in the market. If interest rates fall considerably since you obtained your fixed-rate loan, you can consider a refinance to secure a lower interest rate moving forward.
• Extended repayment period: You can take out a home equity loan with up to 30 years on the term. The lengthy term spreads your principal across more monthly payments. This arrangement gives you more room in your budget for other expenses.
• Tax-deductible interest: Real estate is filled with tax deductions. It’s one of the most attractive perks of the asset. You can deduct every interest payment to lower your tax bill.

How Does a Home Equity Line of Credit (HELOC) Work?

Similar to a home equity loan, a HELOC lets you borrow against your home’s equity. Some lenders extend loans of 75 to 95 percent minus the outstanding loan balance. Another key difference is the way you access funds.

HELOCs are set up as a line of credit so that you can draw against them for a period of up to 10 years. Once the draw period ends and you no longer have access to the funds, you will repay the remainder of what you owe for up to 20 years.

You do not pay interest on a home equity line of credit until you borrow against the principal. This gives you more time to think about how you will use the funds instead of having to repay a home equity loan starting on the first day. The interest on a home equity line of credit is variable and usually higher than on a home equity loan. However, you don’t have to borrow against it. Some people set up HELOCs to build up their reserves in case of an emergency. Just like a home equity loan, HELOCs use your home as collateral. They are second mortgages that you can use for any purchase or investment you desire.

How to Get a Home Equity Loan or a HELOC

To get a home equity loan or a HELOC (Home Equity Line of Credit), there are several steps you need to follow. Here is a guide on how to obtain these types of financing options:

1. Assess your financial situation: It’s essential to evaluate your current financial standing before applying for a home equity loan or HELOC. Consider factors such as your credit score, income stability, and debt-to-income ratio. This assessment will help determine if you meet the eligibility requirements for these types of loans.
2. Research lenders: Take the time to research different lenders and compare their offerings. Find reputable institutions offering competitive interest rates, flexible repayment terms, and excellent customer service.
3. Gather necessary documents: Once you’ve chosen a lender, gather all the necessary documents for the application process. This typically includes proof of income, bank statements, tax returns, and documentation of your current mortgage.
4. Apply for the loan: Fill out the application form provided by your chosen lender. Be prepared to provide detailed information about your financial situation and the purpose of the loan.
5. Await approval: After submitting your application, wait for the lender to review and approve it. This process may take some time as they assess your creditworthiness and verify the information provided.
6. Complete closing process: If approved, you will receive a loan offer from the lender. Review the terms and conditions of the offer carefully before accepting it. Once accepted, you will proceed with the closing process, which typically involves signing loan documents and completing any necessary paperwork.
7. Utilize your funds: Once the loan is closed, you can use the funds from your home equity loan or HELOC for your intended purpose. Whether it’s renovating your home, paying off debt, or funding a major expense, make sure to use the funds responsibly.

Remember to make timely payments on your home equity loan or HELOC to avoid any negative impact on your credit score and potential consequences such as foreclosure. It’s important to understand the terms of your loan agreement and communicate with your lender if you encounter any difficulties in making your payments.

FAQs About How a Home Equity Loan Works

Here are a few frequently asked questions about how a home equity loan works.