One of the biggest hurdles to tapping your home equity could just be in knowing the terminology! If only you could tell your HELs from your HELOCs or LTVs from CLTVs, that critical first step toward using the equity in your home could be that much closer.
How does home equity work? Well, it’s really not that scary. In fact, the handful of terms that follow are really all you need to know to get a grasp on the concept. Home equity, in a nutshell, is the difference between your home’s value and the balance left on your mortgage(s). This difference could also be your biggest financial opportunity that, if handled responsibly, could increase the worth of your home as well as help you achieve other goals, such as paying for college or reducing debt.
To cut to the quick: The amount of equity you can borrow depends on how much equity you have and your ability to repay the loan. To “guesstimate” your home’s value, you can look at recent sales of similar homes in your area and check out online sites such as Zillow.com and Realtor.com.
What will also help is getting a grip on the following terms, so you’ll have an edge when you are ready to move forward with home equity lending:
1. Home equity loan (HEL)—your fixed-rate borrowing option
A home equity loan works similarly to a traditional first mortgage. It could be a first or a second mortgage on your house, requiring fixed monthly payments based on your home equity, for a specific amount of money. You can use it for home improvement, debt consolidation, tuition, a life event like a wedding, or other large expenses.
You can choose your term, typically anything from 10-, 15-, 20- or 30 years, to repay the loan. Your monthly payments will have a fixed interest rate. For example, with a Discover Home Equity loan, you can borrow between $35,000 and $200,000, depending on the amount of equity in your home and your credit profile.
2. Combined loan-to-value (CLTV)—a measure of creditworthiness
Generally, lenders allow you to borrow a maximum combined
loan-to-value (CLTV) of 80 to 90 percent of your home’s value. The combined
loan-to-value refers to the total balance of all outstanding mortgages secured
by your home, including your prospective home equity loan. By contrast,
loan-to-value (LTV) is a simpler number that refers to the size of a loan you
take out compared to the value of the property securing the loan.
To calculate CLTV, first look at your home’s current value compared to all existing mortgages on the home. For example, if your home is valued at $300,000 and you owe $180,000 on your first mortgage, your total available home equity is $120,000 and your current CLTV is 60%.
Now let’s say you’re thinking of getting a second mortgage on the home as well. Most lenders will only lend up to 80% CLTV, which means on a $300,000 home, the maximum loan amount you can have outstanding between all mortgages on the home is $240,000. You already have a $180,000 primary mortgage, which means your maximum possible second lien amount is $60,000. In other words, in this example, you as the homeowner could tap into as much as $60,000 of your equity to use in a variety of ways. Most companies that offer home equity loans will take this CLTV calculation into account when they determine your eligibility and how much you can ultimately borrow, so it’s wise to do the calculation yourself to see where you stand.
Some lenders, like Discover Home Loans, allow a combined loan-to-value of 90 percent (and in some cases 95%), which means in this scenario you could borrow as much as $90,000 (at 90% CLTV) or even $105,000 (at 95% CLTV). This means you potentially have access to more of the money that has built up in your home’s value. To be eligible for these higher CLTVs, you usually must have a higher credit score. Keep in mind there may also be slightly higher APRs for higher loan amounts and some lenders will put caps on how much money you can borrow at a high CLTV.
3. Home equity line of credit (HELOC)—a revolving way to access equity
A home equity line of credit (HELOC) works more like a revolving line of credit that you can borrow against at any time. You’ll typically get checks and a credit card to access the funds, which can usually be used in small or large amounts for anything you want. Some homeowners use a HELOC to pay for a home improvement project if they’re not sure how much it will cost; others use it for ongoing tuition payments or as an emergency fund. On the first day of a home equity line of credit, you are given access to an account with the agreed credit limit. You are only charged interest on withdrawals from the account, which can make the repayment amounts of home equity lines of credit less consistent from month-to-month. One big difference between a HELOC and a home equity loan (HEL) is that a HELOC typically has a variable interest rate. HELOCs may offer a lower starting interest rate than HELs, but the interest rate can change based on U.S. economic trends.
4. Draw period—phase one of a HELOC
A HELOC typically has a variable rate and two separate terms. The first term is called a draw period—or a set length of time, often 5 to 10 years, you can pull from the credit line. During this time you’ll typically need to make minimum monthly payments to your lender, often interest only. These payments are made in addition to your existing monthly mortgage payment.
5. Repayment period—phase two of a HELOC
The second phase of a HELOC is the repayment period, during which you can no longer borrow from the line of credit. During the repayment period, you’ll make principal and interest payments, usually at a variable rate, until the balance is paid in full. The repayment period is usually 10 to 20 years. Once the draw period comes to a close—and depending on how your HELOC is structured—you might continue paying back your loan over time, or in some cases, owe a lump-sum payment for the remainder of the balance.
6. Cap—a limit on your variable HELOC rate
The cap is a limit set by the lender that refers to the highest possible interest rate you’ll pay on your home equity loan. Another way of saying it: If your initial rate is 6 percent and you have a cap of 3 percent, the highest interest rate you might pay would be 9 percent.
7. Prime rate—a benchmark for some HELOC rates
The prime rate refers to the publicly announced rate by financial institutions that is used as a benchmark for credit cards and some HELOCs. For example, if the prime rate is 4.75 percent and your HELOC is prime-plus-2 percent, your rate would be 6.75 percent.
8. Variable rate—a HELOC feature
HELOCs and adjustable rate mortgages (ARMs) usually have a variable rate which will change over time during specific intervals, such as monthly or annually.
9. Fixed rate—a home equity loan feature
A home equity loan has a fixed rate that doesn’t change over time, so you’ll know what your payments will be for the entire length of your loan. The ability to fix your payment is a reason that some borrowers prefer a home equity loan over a HELOC.
10. Teaser rate—an enticement to borrow
Variable rate loans such as HELOCs sometimes have ateaser rate, which is an initial low rate for a specific period used to entice borrowers. It’s important to understand how long a teaser rate will last and what the rate will be when the period of the teaser rate ends.
11. APR (annual percentage rate)—used for loan comparisons
The APR is a more accurate reflection of the interest you’ll pay over the life of the loan because it includes the rate along with any points or fees for the loan. To compare home equity loans, it’s best to look at the APR for each loan you’re considering.
Besides comparing interest rates, ask about any fees you may be charged. Your borrowing decision should be based on your needs, the costs and the service you can expect from your lender.