What is a home equity loan? How does it work?

Types of home equity loans

Home equity loans are usually offered in the following three types:

1. 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. For example, if you borrowed $60,000 for a 20 year term at 8.99% APR, your fixed monthly payments would be $539.45.

2. 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.

Please note: Discover® Home Loans offers home equity loan and mortgage refinance products, but does not offer HELOCs.

3. 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? How much home equity do you 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's 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 combined loan-to-value (CLTV) ratio. CLTV is your loan amount plus your mortgage balance, divided by your home value.

Using our previous example, you could potentially borrow up to $120,000 of your home equity with a lender that approve borrowing up to an 85% CLTV limit. This is because $120,000 plus $220,000 (the mortgage balance), divided by $400,000 (your home value), is equal to 85% CLTV. Some lenders like Discover Home Loans will even let you borrow at under a 90% CLTV limit.

Your borrowing ability is also dependent on your FICO credit score.

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 would with other financing options.

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 in this case.

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.

There are many benefits to a home equity loan with Discover Home Loans. You may be able to obtain low-interest financing for all sorts of purchases from $35,000 to $300,000 without application, origination, or appraisal fees, and no cash is required at closing.

The mortgage interest on a home equity loan may be tax deductible if used for home improvement or refinancing your original mortgage. Consult a tax advisor to see if you qualify.

It is also important to speak with a personal banker who can evaluate your set of circumstances and guide you through the process of selecting a home equity loan.

Personal bankers with Discover Home Loans are available Monday through Friday from 8 am to 10 pm EST. Call 1-855-361-3435 to get started today. Or, request a quote online and we’ll call you back.

Who qualifies for a home equity loan?

What are the requirements to qualify for a home loan?

You need equity in your home. Lenders want to see that you have the ability to repay the loan, so you need adequate income, a good credit score and a history of paying your bills on time.

What can you do with a home equity loan?

Home equity loans offer powerful 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 expenses.

Improve your home

You can use a home equity loan to improve your primary residence. Using the equity you’ve earned with a home equity loan from Discover 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 from Discover 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 a luxury vacation), you can use a home equity loan.

You could also 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 other niche financing options.