In theory, any loan that involved making use of the equity in a home can be defined as a home equity loan.
But in practice, when the term home equity loan is used, it refers to a lump sum term loan borrowed against the home value that is repaid by recurring installments over a specified period of time.
While HELOCs are home equity loans by definition, they are referred to as HELOCs instead in practice.
Home equity loans can take the shape of many forms. The most common being:
- Second mortgage
- Equity loan on unencumbered property
- Cash out refinance
A second mortgage refers to taking a second loan against the property in question. The first being the original home loan taken to purchase the house. And the second lien for a cash term loan to release the equity built up in the house.
Unencumbered property refers to property that has been fully paid up with no debt outstanding. An owner of such a property can either cash out by selling it or keep the house and get access to funds via a home equity loan.
A cash out refinance refers to a homeowner refinancing an existing mortgage. This time getting a larger loan after taking into account the value appreciation of the property and equity built up over time.
Benefits of home equity loans
The main logic behind these loans is that when the house is worth much more than what is owed on it, it makes sense for a homeowner to borrower against it when needed as secured loans are some of the cheapest around.
On top of the lower interest rates, equity loans tend to be much larger quantums which is a direct result of home value.
This is as opposed to the smaller amounts one can get for a personal loan or a credit card.
And because these are secured loans that minimize the risks of lenders, they tend to be more easily approved.
This does not mean that approval is guaranteed. It just means that credit assessment can be more lenient.
In the even of a default, banks can foreclose the property and pay off the loan with proceeds from the sale. Making it a very safe investment on their part.
One more advantage that borrowers don’t often realize is the potential tax benefits that come with it.
Some of the interest might be tax deductible. A qualified accountant should be able to shed more light on it for you.
How it works
The most common reasons people decide to tapped onto their home equity for extra funds are for:
- Business use
- Remodeling to increase value of house
- Investment purposes
- Family emergencies
- Debt consolidation
The amount that a borrower can borrow depends heavily on the appraised value of the property.
This is because lenders tend to exercise a loan to value limit that a borrower can borrow.
Together with the existing mortgage currently on the house, the loan amount can then be calculated.
For example, if a house is appraised at $220,000 and the current home loan has $150,000 outstanding, a lender implementing a 80% LTV would make the qualified loan amount $176,000 ($220,000 x 80%). Deducting the original loan balance from the maximum loan allowed results in $26,000 ($176,000 – $150,000).
This means that the maximum home equity loan that the borrower is eligible for is $26,000. If he has a smaller appetite, he can choose to take up a lesser amount of say $15,000 or $20,000.
In the case of a second mortgage, the borrower will now have 2 home loans to service.
Both of them having different terms and interest rates. With the first retaining a first-priority claim on the house and the second lender having a second lien.
This also means that the second loan can have a shorter or longer tenure than the first, resulting in an earlier or later pay off date according to it’s amortization schedule.
Should the first be paid off before the second in future, the second moves up to become the first.
When the loan involved unencumbered property, the lender will have the first lien and take the house as collateral since there are no existing loans against it.
it would be akin to the house having a housing loan to repay just like how the owner first purchased the house with traditional financing.
When the cash out refi route is use, the new equity loan is basically combined with the first mortgage to form a new loan that consist of the two.
This new loan will consist of one interest rate as opposed to a first and second mortgage combination.
When approved, the funds are disbursed by the lender to the borrower’s account as a lump sum and interest rates are charged immediately with the first installment payment due on the following month.
However all of them requires significant closing costs with the refinance usually being the most affordable.
How to choose the best home equity loan
The task of choosing the best home equity loan is more of less the same as selecting any mortgage.
Conventional mortgage wisdom should be applied when weighing up one against another.
The most critical factors for comparison being:
- Interest rates
- Prepayment penalty fees
- Settlement costs
- Loan amount
- Lender reputation
A particular concern that borrowers have is when appraisers appointed by the lender does not value the property within the expectations of the home owner.
While it is partly because it affects the loan amount the borrower qualifies for since it directly impacts the loan to value, the source of their worry is something more sinister.
The fear is that should they sign up for a new loan with an understated value on the property, it serves as a precedence for how much it should be valued in the future.
This will affect the price the house can be sold for in future or more loans against it’s value in future.
While this might sound odd to some people, these are justified concerns of home owners. And it is not uncommon to find borrowers walking away from home equity loans due to the lender undervaluing their proprieties.
To put it into perspective, if you know your house is worth $300,000, would be willing to pledge it as security for a loan of just $150,000?
In this aspect, a lender could be trying to pull a fast one of the borrower. As should the borrower default on the loan, the lender would be in prime position to acquire possession of the property on the cheap via foreclosure.
Finally, while it is legitimately fine to borrower against your house to spend on luxuries and travel, remember that most people dig themselves into a deep debt problem because of such mindsets.