How Does a Home Equity Loan Work

How Does a Home Equity Loan Work?

Kali Hawlk Unison

Have you owned your home for a few years? If you’ve been paying your mortgage and/or your home has appreciated in value since you bought it, you may be able to tap into your home equity.

A home equity loan is a source of capital that homeowners can use to help meet a need or reach a goal. You could fund your next renovation project or car purchase, or pay off high interest credit card debt — plus a lot more.

However, there are also disadvantages to this type of loan. Below, we discuss the pros and cons and how to know if a home equity loan is a good option for you.

Understand How Home Equity Loans Work

The difference between a home’s value and the homeowner’s outstanding mortgage balance is “equity.” To calculate your equity, follow this formula:

Home Value – Mortgage Loan Balance = Home Equity

A home equity loan allows you to borrow against the equity in your home.

If you do the calculation and realize you don’t have at least 20% equity in your home — the amount most lenders want to see before letting you borrow money against the value of your home – you’ll likely need to increase that equity before getting a loan.

You can build equity by paying down your mortgage over time. With most mortgage loans, a portion of each mortgage payment goes toward paying down your principal balance and a portion pays the interest on the loan.

You also gain equity if your home significantly appreciates in value.

How to Get a Home Equity Loan

You need to apply for a home equity loan just like any other loan. This involves sharing your credit history and other information. Once a lender receives your application, they’ll want to schedule an appraisal on your home to determine its value. The appraised value of your home will determine how much you can borrow (if any).

If you bought your home years ago and the market has appreciated, you could find the lender will allow you to borrow more than you initially planned. If this is the case, be careful! It’s still a loan — meaning you still need to pay it back with interest, and you need to make sure you’re comfortable with the monthly payment. Your specific monthly payment and interest rate are determined by your loan terms.

And with home equity loans, banks typically have minimums that are in the 5-digit range. Some require you to take out at least $10,000. Others won’t make a home equity loan unless you borrow $25,000 or more.

This is why these loans are best used when you need large sums of money for major projects or goals – like home improvements or funding a child’s education.

A Home Equity Loan Is Not a HELOC!

If you’re interested in getting a home equity loan, you’ve probably heard of a home equity line of credit, or HELOC. Sometimes, people use the terms interchangeably. But while they share some similarities, they’re not the same thing.

The value of your home and the equity in it can secure both a home equity loan and a HELOC. But when you take a home equity loan, you receive a lump sum of cash. Remember, those last three letters in HELOC stand for line of credit.

HELOCs give you a line of credit that works more like a credit card, in that it revolves. Say you got a HELOC for $50,000. That’s a line of credit with a limit of $50,000 for a set period of time (referred to as a term).

You could borrow $10,000 to redo your landscaping this summer, and then pay that balance back. During the time you borrowed the $10,000, only $40,000 would be available from your HELOC. But as soon as you repaid your balance, you’d have the full $50,000 available again.

Given that both typically hold a second lien position (for most people their existing mortgage holds the first position), interest rates on home equity loans and HELOCs tend to be a point or two higher than current first mortgage interest rates.  This is because of the added risk of the junior position – if the home is foreclosed on, the mortgage in first position will be paid off first, followed by the home equity loan or HELOC.

The Pros and Cons to Consider Before Taking a Loan

Here’s a quick rundown of the ways a home equity loan can benefit you as a homeowner:

  • They come with relatively low interest compared to rates on personal loans or credit cards.
  • You receive a locked-in rate on your loan that won’t change, even if interest rates rise.
  • Home equity loans provide increased liquidity — a big deal, as by default your cash is locked into a house until you sell it. This loan gives you access to the value of your property.

Again, home equity loans might be good options if you need a large sum of cash. They can help you get the cash you need upfront for a big project or renovation that, over time, can actually increase the value of your home.

But they’re not a perfect solution. Don’t forget to think about these downsides:

  • Just like your mortgage, home equity loans come with closing costs that can include an appraisal, lender fees, and settlement costs.
  • Yes, a home equity loan adds leverage — and if you’re leveraged during a market downturn where your home value drops, you could end up owing more on your house than it’s worth.

The biggest downside is that it’s a loan — which means debt. That comes with monthly payments.

A home equity loan is not your only option if you need cash for something like making home improvements or paying for a child’s education. If you want to avoid debt, consider an investment program like Unison’s instead.

Unison can provide you with a lump sum of money.  It’s not a loan, which means homeowners don’t make monthly payments or pay any interest. Instead, the money provided is an investment. In exchange, Unison receives a share of on the change in value of home when you sell.

Is a Home Equity Loan Right for You?

A home equity loan can help you accomplish long-term financial goals, such as paying off high interest debt or funding a home improvement project that could increase your property value.

You should avoid these loans to fill short-term cash flow needs, especially if that’s a result of overspending. (Your solution in this case? Examine and reduce your spending and set up a budget, rather than continuing to look for ways to tap into home equity.)

Home equity loans are fairly straightforward to apply for and obtain. They can help homeowners with a lot of financial goals. But they are not without risk.

Don’t forget to look at other options – like the Unison HomeOwner program — that can help you accomplish your goals without adding debt.

About the Author

Kali Hawlk

Staff Writer

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Kali is a writer, content strategist, and consultant. She has many years of experience writing about personal finance and real estate. She appreciates the chance to educate people about home-buying.

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