Are you a homeowner? As you pay down your mortgage, you build equity in your property. This equity can then be leveraged in various ways, including through a home equity loan.
So, what exactly is a home equity loan? How can you obtain one? What are its benefits? And how does it differ from other forms of credit, like a home equity loan of credit (HELOC)?
Keep reading to find answers to all these questions!
What is a home equity loan?
A home equity loan is a type of term loan where you use the equity in your home as collateral.
Equity refers to the difference between the current market value of your home and the amount you still owe on your mortgage. The more you have paid down your mortgage, the more equity you have built up.
In simple terms, a home equity loan lets you borrow against the value you’ve accumulated in your home over time. The maximum amount you can borrow typically depends on the equity you’ve built up, but it’s usually capped at 80% of your home’s value.
This loan product is often attractive because it allows you to borrow a larger sum at a lower interest rate compared to unsecured loans. Home equity loans can be used for various purposed, such as home renovations, medical bills, debt consolidations, and other major expenses.
The loan is repaid in fixed monthly payments, and once it’s paid off, the loan can be renewed. However, since it’s secured by a mortgage, it’s important to remember that failing to make repayments could result in the lender foreclosing on your home.
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How does a home equity loan work?
To access a home equity loan, you must be a homeowner with equity in your property. Specifically, you need to own at least 20% of your home’s value to qualify for this type of loan. The more equity you have, the higher your borrowing potential will be.
As mentioned earlier, a home equity loan allows you to borrow up to 80% of your home’s appraised value, minus any remaining balance on your mortgage.
The application process for a home equity loan is similar to applying for a standard mortgage. Lenders will assess your financial situation, including your creditworthiness and ability to repay the loan, before approving you. You’ll need to demonstrate that you can manage the additional debt.
As with any loan, timely repayment is crucial. Failure to make your monthly payments could lead to serious financial consequences, including foreclosure on your home if you default on the loan.
How to calculate your home equity?
If you are unsure how much equity you have in your home, it’s easy to calculate. Your home equity is simply the difference between your home’s current market value and the remaining balance on your mortgage.
To calculate your equity, use this formula:
Market value - mortgage balance = equity owned
Here are two examples to illustrate:
Example 1
Your home is values at $450,000.
You still owe $369,000 on your mortgage.
Equity = $450,000 - $369,000 = $81,000, or 18% of the home’s value.
In this case, you don’t have enough equity to qualify for a home equity loan (you need at least 20%).
Example 2
Your home is values at $450,000
You owe $315,000 on your mortgage.
Equity = $450,000 - $315,000 = $135,000, or 30% of the home’s value.
In this case, you have enough equity to qualify for a home equity loan.
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Advantages and disadvantages of a home equity loan
A home equity loan, like any financial product, had both advantages and disadvantages.
What are the advantages?
- Access to a larger loan amount based on the equity in your home.
- A fixed repayment schedule, making it easier to manage.
- Flexibility in how the funds are used (renovations, tuition, etc.).
- A lower interest rate compared to unsecured loans.
What are the disadvantages?
- The risk of foreclosure if payments are missed.
- A higher interest rate compared to some other secured loans of credit options.
Home equity loan vs. home equity loan of credit (HELOC)
A home equity loan is often compared to another popular option for homeowners: the home equity line of credit (HELOC).
A HELOC is a revolving line of credit secured by your property. Unlike a lump-sum home equity loan, a HELOC allows you to borrow money as needed, up to a pre-approved credit limit. You can borrow, repay, and borrow again, depending on your ongoing needs.
With a HELOC, you can typically access up to 65% of your property’s market value. Payment will vary on how much you’ve borrowed, and you only pay interests on the funds you actually use.
Which options is better: home equity loan or HELOC?
The choice between a home equity loan and a HELOC depends on your specific needs and financial situation:
- If you know exactly how much money you need for a specific purpose, a home equity loan might be the better option since it provides a fixed amount with a fixed repayment schedule.
- If you’re unsure about how much money you might need and prefer more flexibility, a HELOC could be more advantageous, as it allows you to borrow and repay funds as your needs change.
To make the best decision, it’s a good idea to discuss your options with a mortgage broker who can help guide you based on your individual circumstances.
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