What Is a Home Equity Loan?
- Home equity is the portion of your property value that belongs to you and not your mortgage lender.
- To calculate home equity, subtract the total mortgage balances from the current home value.
- Most lenders will loan against 80% to 90% of your home equity.
Home equity loans allow homeowners to exchange home equity for cash without selling their property. Home equity loans are installment loans that usually have fixed interest rates. That means you pay them off in equal monthly payments until the loan balance is zero.
Home equity loans are mortgages, which means your property is collateral, and your home can be foreclosed if you don't repay the loan as agreed. When you take out a home equity loan, your lender records a lien against your home with your county recorder’s office.
What Is Home Equity?
Home equity is the part of your home’s value that you own – not your mortgage lender. Home equity is the difference between what your home is worth and what you owe on it. If your home is worth $200,000, and your mortgage balance is $150,000, you have $50,000 in home equity.
$200,000 - $150,000 = $50,000.
You can express home equity in dollars, but lenders normally calculate home equity as a percentage of your property value. To do that, you divide your mortgage balance by your property value, then subtract the result from 1. For instance:
$150,000 / $200,000 = .75
1 - .75 = .25
In this case, you have 25% home equity. Your current loan-to-value ratio, or LTV, is 75%. The LTV calculation becomes very important when applying for a home equity loan.
How Does a Home Equity Loan Work?
The process for getting a home equity loan is very similar to that of getting a mortgage when you buy the property. If you already have a mortgage on your home, a home equity loan becomes the second mortgage against your home. One name for a home equity loan is "second mortgage.”
Being in the second position makes the home equity loan different. For one thing, if you default on (don't pay) either of your mortgages, and the property is foreclosed and sold, the lender with the first mortgage gets paid first. The home equity lender only gets paid if there is enough money left over to cover the loan balance. This makes home equity loans a little riskier than first mortgages, and that’s why they have higher interest rates.
When you take out a home equity loan, you’ll go through escrow and sign your documents. Your lender wires your loan proceeds or gives you a check. Over the loan’s term, you’ll pay the loan back in equal installments until your balance is zero. At that point, your lender releases the lien against your home.
How Much Can You Borrow With a Home Equity Loan?
The added risk of home equity financing means you can’t borrow against all of your home equity. Most lenders limit home equity lending to 80% or 85% of the home’s value. A few will go to 90% for highly-qualified borrowers.
To see how much you can borrow, you’ll need:
An estimate of your property value
Your current mortgage balance
Your lender’s maximum LTV
Assume that your home value is $300,000, your current mortgage balance is $227,000, and your lender is willing to lend up to an 85% LTV. Here’s what you do:
Multiply your property value by the lender’s maximum LTV. $300,000 x .85 = $255,000.
Subtract your current mortgage balance: $255,000 - $227,000 = $28,000If you qualify, you can borrow up to $28,000.
What Are Home Equity Loan Interest Rates?
Home equity loan interest rates are higher than those of first mortgages. In addition, the spread between rates for borrowers with good and bad credit are wider than they are with first mortgages.
A look at nationally advertised rates shows that borrowers with the highest credit scores can choose a 15-year home equity loan with an interest rate of 4.6%. In comparison, top-tier borrowers taking a 15-year first mortgage may be offered 2.25%.
The spread between rates for borrowers with good-to-excellent and fair-to-poor credit is greater with home equity loans. As of this writing, advertised rates range between the low 3% range for highly-qualified applicants to just under 12% for less-qualified homeowners.
How to Apply for a Home Equity Loan
The home equity loan application process is similar to that of a first mortgage. You complete the standard Fannie Mae 1004 form and provide information about your property, income, assets, debts, and what you plan to do with the money.
Your lender pulls your credit and will probably verify your employment. Most underwriting today is completed by software, with humans verifying the information and checking documents like pay stubs and bank statements. You‘ll probably have an underwriting decision in just days or even hours. Your lender may use an automated property valuation service, or you might have to pay for an appraisal.
Once both you and your property have been examined and approved, your lender will draw loan documents and send them to a title company or (in some locations) a lawyer. You’ll sign them and receive either a transfer into your account or a check for your loan proceeds.
What Are Home Equity Loan Closing Costs?
Home equity closing costs mirror those of a first mortgage but tend to be lower. Some lenders wrap them into a single fee, while others list every line item. Some require new title insurance, and others only require a title search. The important thing to remember is that closing costs are part of the package, and you need to evaluate the total loan cost when shopping, not just the interest rate.
The loan’s APR disclosure, which is required by law, incorporates loan fees and interest charges and makes it possible to compare loans with different rates and closing costs head-to-head.
How to Get the Best Home Equity Loan
The best home equity loan for you may not be the best loan for your neighbor. Finding the best home equity loan involves two steps – determining the right loan amount and product for your needs and then finding the best deal on that product.
To choose the best home equity loan, you’ll consider:
How much money do you need?
How much home equity do you have?
What will your LTV be if you borrow as much as you want?
What payment can you afford, and how does that affect your loan term and loan amount?
First, add the amount you want to borrow to your current mortgage balance. Then divide by your home value. Suppose that you owe $275,000 on your home, and it's worth $400,000. You'd like to borrow $60,000.
Add $60,000 to $275,000 to get $335,000.
Divide $335,000 by $400,000 to get 83.75% LTV.
This means you’ll have to look for a lender that allows LTVs higher than 80% or borrow less.
What Is the Difference Between a Home Equity Loan and a Second Mortgage?
There is no difference between a home equity loan and a second mortgage. People often call home equity loans “second mortgages” because most of them already have one mortgage on their home, the one they used to purchase the property.
Second mortgages are in what’s called “second position.” That means if you don't pay your mortgages as agreed and your home is sold in a foreclosure sale, the lender with the first mortgage gets repaid first. The second mortgage holder only gets reimbursed if there is enough money from the sale to cover what's owed. Because of this added risk, home equity mortgage interest rates are higher than first mortgage interest rates.
What Is the Difference Between a Home Equity Loan and a HELOC?
A home equity loan is an installment loan. That means you get a lump sum when you borrow, and then you make monthly payments until your balance is zero. The interest rate is usually fixed, and your payments (installments) are the same every month. Home equity loans are suitable when you need a large sum of money at once – perhaps to consolidate debt, pay for an addition to your home, or buy another property.
HELOC is short for home equity line of credit. It's like having a credit card, but your home secures the loan. That's why HELOC interest rates are much lower than those of credit cards. HELOCs typically have variable interest rates. You pay interest only on the amount of credit that you use.
HELOCs are best when you need flexibility – for instance, if you're using the loan to pay college tuition or you're renovating your home with a series of projects over time. HELOCs can also function as emergency cash for your small business or household.
What’s the Difference Between a Home Equity Loan and a Cash-out Refinance?
With a home equity loan, you leave your first mortgage in place and add a second mortgage. When you take out a cash-out refinance, you replace your existing mortgage with a larger loan and take the difference in cash. Cash-out refinancing can be expensive because lenders add a surcharge to your closing costs for that feature. And the surcharge is a percentage of the entire loan amount, not just the cash-out.
When you're looking to borrow against your home equity, compare the cost of both options to make sure that you're choosing the cheapest loan.
What Are the Best Uses for a Home Equity Loan?
You can use home equity financing for almost any purpose. However, personal finance experts recommend that you treat your equity like the valuable asset it is and that you avoid using long-term loans to finance short-term things like vacations or shopping sprees. Most home equity loans have terms ranging from ten years to 30 years. Do you want to be paying for your wedding when your child is heading off to college?
Good uses for home equity loans provide long-term benefits. They include home improvements that add property value, a college degree to up your earning potential, rental property, or consolidating debt with high interest rates. You can use home equity loans for short-term purchases, but in that case, you should increase your monthly payment to get rid of the debt sooner.
What Is Home Equity Loan Subordination (and Why Is it Important)?
Most borrowers don't understand or care about loan subordination. Loan subordination doesn't appear on peoples' radar until they want to refinance their first mortgage and leave the second mortgage alone.
In that case, the lender with the second mortgage must subordinate it to the new first mortgage. That means the home equity lender must agree to get paid last in the event of a foreclosure sale. If that doesn't happen, you won't be able to refinance your first mortgage.
This means that you need to look at the subordination agreement of your home equity loan documents to see what would happen if you refinanced your first mortgage. Some lenders will automatically subordinate. Others will not if you have missed or late payments or your first mortgage balance will increase. There may be a charge to subordinate your loan.
What happens if your home equity lender refuses to subordinate your loan? You may have to refinance your second mortgage with a lender that has a better subordination agreement. Or you may wish to wrap your second mortgage into your first mortgage refinance.
Can You Refinance a Home Equity Loan?
You can refinance a home equity loan or HELOC. There are a few reasons for doing this:
To replace a variable rate loan with a fixed-rate loan
To get a loan with a better interest rate.
To lower your payments by extending your loan repayment
To pay off a loan that has a balloon payment
To cash out more equity if your home’s value has increased
It might make sense to refinance your first mortgage and wrap the home equity balance into the new loan. That usually gets you a better interest rate. You’d only do this if you have enough home equity to avoid mortgage insurance and if you can improve on the terms of your existing first mortgage.
What Is a “Purchase Money Second” Mortgage?
A "purchase money" second mortgage is a home equity loan that you use to fund part of your down payment. The first and second mortgages are secured by the property you're buying. This arrangement is also called a “piggyback” loan. You’d take out a purchase money second mortgage if you don’t have 20% down and you want to avoid paying mortgage insurance.
If you put 5% down and borrow 15% with the home equity loan and 80% with a first mortgage, the deal is called an 80/15/5 to reflect the loan and down payment percentages. If you put 10% down, the piggyback is called an 80/10/10.
How Do You Pay Off a Home Equity Loan?
There are four ways to pay off a home equity loan. The first is to make your payments until your balance is zero. The second is to pay it off when you sell your property. The third is to refinance your first mortgage and wrap the home equity loan balance into the new loan. And the last is to refinance the home equity loan with a new loan.
Home equity is a valuable asset that can improve your future financial security. Treat it with respect and use it wisely.