Introduction to Home Equity Loans
A home equity loan makes it possible for you to turn the equity in your home into cash in your pocket. Whether you want to leverage the money in your home to pay for your daughter’s wedding, upgrade the bathrooms in your house or pay less interest on other debts, home equity loans are an incredible resource for homeowners.
Types of Home Equity Loans
Home equity loans are usually offered in the following three types:
- Traditional home equity loan: This type of home equity loan becomes a second mortgage on your home. Traditional home equity loans allow you to leverage a fixed sum of money at a fixed interest rate. At Discover Home Loans, we offer 10, 15, 20 or 30 year terms without application, origination, or appraisal fees, and no cash is required at closing.
- Home equity line of credit (HELOC): This type of home equity loan is a short to medium term loan with a lot of flexibility. With a HELOC, you only borrow what you need, and you only pay interest on the money you’ve borrowed. Since most HELOCs have 5, 7 or 10-year terms, the balance of your HELOC is converted into a traditional second mortgage once it expires. This means you’ll end up with a second mortgage in the amount of your HELOC balance.
- Cash-out refinance loan: This type of home equity loan allows you to increase the amount of your current mortgage by refinancing the total borrowed amount into a new loan. Instead of having two mortgages, a cash-out refinance loan combines the borrowed amount with the principal of your existing mortgage.
What is Home Equity and How Much Home Equity Do I Have?
Your home is one of your greatest assets. As you pay down your mortgage and property values in your neighborhood rise, the cash value of your home increases. That cash value is your home equity. It is the value of your homeownership.
To calculate your home equity, you must know the total amount of all debts secured by your home (e.g. your current mortgage, business loans or private debts), and you must know the current fair market value of your home.
Simply put, your home equity can be calculated by subtracting all debts secured by your home from your home’s fair market value.
For example, if your home is worth $400,000 and your current mortgage is $220,000, then you have $180,000 of equity in your home. Your borrowing ability depends on your closed loan-to-value (CLTV). CLTV is your loan amount plus your mortgage balance, divided by your home value. Discover Home Loans accepts CLTV less than 90% with a maximum loan amount of $200,000.
Using our previous example, you can borrow up to $140,000 of your home equity. This is because $140,000 plus $220,000 (mortgage balance), divided by $400,000 (home value), is equal to 90% CLTV. Your borrowing ability is also dependent on your FICO score.
What Can I Do With A Home Equity Loan?
Home equity loans offer wonderful financing opportunities for homeowners because of their flexibility.
You can use the money you get from a home equity loan to pay for major expenses or life events, to consolidate high-interest debt, to improve your home, or pay for other things like education.
Improve your home
You can use a home equity loan to improve your primary residence. You can kiss the days of wishing for that gorgeous HGTV renovation goodbye, and start your own remodeling project. Using the equity you’ve earned to improve your home is a smart way to leverage your funds. In fact, some improvement projects can instantly increase your equity by increasing the value of your home.
High-interest debt consolidation
High-interest rates on unsecured debts can become a hurdle to becoming debt-free. Since home equity loans usually have lower interest rates than unsecured loans, using a home equity loan to pay off high-interest debt can be a smart move. You may enjoy a lower monthly payment on your new loan.
Pay for big-ticket purchases
Instead of using a credit card or unsecured personal loan to pay for big-ticket items (like school tuition, a wedding or luxury vacation), you can use a home equity loan. You can even use a home equity loan to pay off an unexpected expense. Home equity loans enable you to use your big-ticket asset (your home) to pay for all kinds of big-ticket expenses.
Home equity loans often offer lower rates than other types of financing. This is why you should consider using home equity to finance a number of things that you might have instead financed using higher-interest credit cards or niche financing options.
Almost any type of primary residence can be used to secure a home equity loan including condos, townhomes and of course, single-family residences. Commercial properties, investment properties and manufactured homes cannot be used to secure a home equity loan with Discover Home Loans.
It is important to take inventory of your personal finances before obtaining a home equity loan. Your house is the collateral for your loan, so failure to repay can put your home at risk. Always borrow intelligently, and make sure you understand how home equity loans work before you get one.
What are the Pros and Cons of Home Equity Loans?
Home equity loans are not always the best financing option for short-term expenses. For example, if you use a 10-year term home equity loan to purchase a car that you own for five years, you could end up paying more interest than you should. This is because you’re paying on the loan for a longer period than you likely would with a car loan. While a car loan may have higher interest rates, the term of the loan is not as long, so the financial benefit provided by using a home equity loan may be negligible.
You also want to avoid using a home equity loan to consolidate high-interest debt if you are going to accrue new high-interest debt again. Debt consolidation is designed to reduce financial stress. However, using a home equity loan unwisely will only create more financial stress for you in the future if you obtain one for the wrong reasons.