How Do Home Equity Loans Work?

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Do you want to remodel or add-on to your house but do not have enough cash in the bank to cover the expenses? The money might already be sitting in your house. By using the equity value of your house, a home equity loan (also known as a second mortgage) can fund these projects. Additionally, you can usually get a lower interest rate with a home equity loan than other types of personal loans.

Home Equity Loans vs Home Equity Lines of Credit

Home equity loans shouldn’t be confused with Home Equity Line of Credit (HELOC). A home equity loan is a loan with a fixed interest rate and fixed term length that allows a homeowner to borrow the value of their home minus the amount still owed. For example, if a house is valued at $200,000 and $125,000 has been paid so far, the homeowner can borrow up to $125,000.

If the house is paid in full, they can borrow up to the total assessed value of the home (in most instances).  Similar to other loans, the borrower will pay back the borrowed principal plus interest accrued.

A home equity line of credit, often called a HELOC, allows the homeowner to borrow the amount of their equity over a more flexible period of time. The homeowner can borrow as much (or little) as they need. A HELOC is a secured revolving line of credit, similar to credit cards, with a variable interest rate. This is more ideal for a person with recurring expenses and an uncertain timeframe of when their project expenses will finish.

Both a home equity loan and HELOC can both be used to remodel, renovate, or add-on to your house, consolidate debt, or pay for other major purchases. However, a home equity loan is a modern equivalent to “betting the farm.” If you default on the loan, the lender can repossess your house to recoup the losses. Missing payments on a home equity loan is a more direct path to “losing the farm” than other types of loans.

Which Is Better?

Choosing between home equity loans and HELOCs can be a somewhat difficult choice. There are just as many options for a “second mortgage” as there was for the original mortgage loan.

Home Equity Loan

Here are the advantages of a Home Equity Loan:

  • Fixed Interest Rate
  • Ideal for a single expense where all money borrowed will be withdrawn within a short timeframe
  • Fixed loan terms such as a 15-year or 30-year term

Home equity loans are best for those that know the exact amount they will be borrowing. It is great if you want to secure an interest and monthly payment, similar to a home mortgage loan.

HELOC

For those that plan on having an ongoing project (like building a weekend home) and will need to borrow a different amount of money each month, a HELOC might be the better option. Here some of the advantages of a HELOC:

  • Better if you will make several “draws” without a defined timeline
  • Minimum monthly payment is normally only on the interest accrued for the month on amount that has been withdrawn already
  • Repayment terms up to 15 years in many instances, but can vary widely bank to bank
  • Ideal for those that need to borrow for multiple reasons

Differences Between a Home Equity Loan and a HELOC

The primary difference between a home equity loan and a HELOC is the type of interest rate. Traditional home equity loans have fixed rates (adjustable rates are also available). HELOCs are variable. While this might not be a big deal, it can make a huge difference if interest rates rise significantly. Each bank charges a different interest rate – the common trend is to charge the Prime Rate plus several percentage points.

Regardless of which loan is more conducive for your situation, either is better than most credit card and personal loans. Those will usually charge significantly higher interest rates.

How To Apply For A Home Equity Loan

Applying for a home equity loan is very similar to the application process for a mortgage. You can begin the process online with a local or national bank, but will probably have to complete some paperwork in person to close the deal.

Here is a step-by-step guide on what to expect during the application process:

1. Choose between a home equity loan or HELOC

Decide which is best for your situation. If you know the total amount you want to borrow and can start repaying immediately, a home equity loan is better. Otherwise, choose a HELOC if you will withdraw over the course of several months or years and are unsure of the final amount you want to borrow.

With either financing option, research the repayment terms as they can differ widely between banks. You don’t want to borrow money but be unable pay it back on time because of a short repayment window.

2. Bring Your Paperwork

Similar to a home mortgage loan, you will need to provide personal financial information. This will likely consist of your most recent tax returns, proof of income and employment, total net worth, and proof of homeowner’s insurance. Most banks are not going to lend to somebody if it doesn’t look like they can make the monthly payments on the home equity loan.

3. Prepare For A Property Appraisal

Depending on several factors including the amount you want to borrow, any previous relationship with the lender, or how recently your house was previously appraised, the bank will most likely hire an appraiser to provide the current market value of your house and property. You will most likely have to pay the appraisal fee which will be several hundred dollars, but this appraisal helps the bank determine how much money they will lend you. As market values constantly fluctuate, you may have more equity than you previously realized!

Factors that will help influence the current market value include the following:

  • Age and physical condition of the house
  • Location and neighborhood
  • Number of bedrooms and bathrooms in the house
  • Total square footage of the house
  • Total acreage of the lot
  • Additional amenities such as a swimming pool, premium countertops, or professional landscaping

The appraiser will most likely take pictures of the house and might even do a walk-through for a more in-depth appraisal. The appraiser will also compare your house to similar houses that have recently been appraised. This ensures that their appraisal is consistent with the current market value.

4. Get Approved!

If you are pleased with the appraisal results and terms of the loan, you can start borrowing money. To spend the money, you might be issued a separate checking account and debit card. This will allow you to pay for expenses directly from the home equity loan or HELOC. Just remember that you will have to pay a monthly payment of some amount. Remember to keep some money aside to avoid any financial pitfalls.  Similar to any loan, the more you borrow the higher your monthly payment.

Summary

A home equity loan or HELOC might be the most affordable financing option for most homeowners that need to borrow a sizable amount of money. While paying with cash that has been diligently saved is always the best way to pay for large expenses, because you do not owe anybody a monthly interest payment, it’s not always achievable. When used responsibly, homeowners can borrow money at a “discount”. They will also still improve the value of their house or consolidate their debt at a lower interest rate.

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