Home Equity Loan & Line of Credit
What is a Home Equity Loan & Line of Credit?
A home equity loan or line of credit is a form of lending that allows a borrower to use their home as collateral to secure an additional loan amount. Acting as an additional mortgage, a home equity loan essentially borrows against the property. This is assuming the initial mortgage, used to originally purchase the home, has enough of it paid off already.
A home equity loan is dependent upon a home’s current value and how much of the original mortgage has been paid off. Banks issue home equity loans for the same reason they issue mortgages: if a borrower cannot pay, the value of the house should be able to sell and cover the borrower’s defaulted loan amount. The only difference is that home equity loan amounts are based on how much equity a homeowner has in their home, i.e. how much of the original mortgage has already been paid off.
The following are two major types of home equity loans:
Fixed-Rate Loans: A fixed-rate loan is a one-time loan amount is issued to the borrower. The contract provides the terms of how long the borrower must repay the loan in addition to the interest rate. The interest rate and incremental payment amounts do not change throughout the term of the loan. Should the house sell at any time, the borrow is still responsible for repaying the loan in its entirety per the contract.
Lines of Credit: A line of credit is a requested maximum balance that a borrow has available to them courtesy of a bank or financial institution. Borrowers of a line of credit cannot use more than the maximum amount provided to them, but they also don’t have to use much or any of the credit as well. Interest only needs to be paid and comes into play when the borrow spends money from the line of credit. Lines of credit revolve, so like a credit card, a borrower can maintain the same maximum spendable limit if they pay back the amounts they borrow.
Example of a Home Equity Loan & Line of Credit
Let’s say you purchase a home for $225,000 with a down payment of $25,000, and borrow $200,000. Your equity at closing is $25,000. Let’s assume you make good on your payments over the next five years and have successfully paid down $15,000 of the principal loan, and currently owe $185,000. Let’s also assume that your home’s value has increased. Currently, its worth $285,000. Your equity would then be $100,000.
You could use your home equity, which in this example is $100,000, to secure a line of credit or home equity loan. Most lenders will determine an interest rate and payment amounts, for a home equity loan, and maximum line of credit with an interest rate, for a line of credit. In addition, your location and credit history will factor into a home equity loan and/or line of credit final approval.
Home equity loans and lines of credit are great ways to acquire additional funds if you are already a homeowner with some equity built up in your home. Keep in mind that with these lending methods, you are putting your home up as collateral, so if you are unable to repay the loan your house can be taken and sold to recoup the owed funds. These lending methods are good for borrowers who know exactly how much they will need to borrow. If you are interested in funding a home remodeling project, or paying off an education debt, be sure to weigh the pros and cons and do not be tempted to borrow more than you need.