Home Equity Loan: How Does It Work?

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A home equity loan is a great option if you're needing cash to do a home remodel, buy more property, or cover other big expenses. But is this the right kind of loan for you?

To answer that, you have to understand what a home equity loan is and other options you may have.

Read on for a short guide that will help you understand the ins and outs of these types of loans.

What Are Home Equity Loans?

First, to understand what the loan is, you have to know what equity is. Equity is the difference between your home's worth and the remaining balance of your mortgage. For example, if your home is worth $200,000 and you still owe $80,000 on your mortgage you have $120,000 in home equity.

An equity loan is using that equity as collateral for the money you need. Essentially giving you a second mortgage to take care of your bigger expenses. But this also means you're putting a second lien on your home.

But there are few other factors lenders will consider when determining how much you're eligible to borrow.

Determining Eligibility

Many lenders will use a combined loan-to-value ratio (CLTV) to determine how much you are eligible to borrow against your equity. This rate will vary from lender to lender.

To give an example, let's say your home is worth $200,000, your mortgage balance is $120,000, and your lender's max CLTV ratio is 80%. You would multiply $200,000 by .8 and then subtract $120,000, which would give you $40,000 in borrowing power.

Lenders may also require you to purchase points before receiving your loan. Points are a type of prepaid interest that lowers the total amount of interest you'll pay monthly. The cost of these points is generally one percent of the loan total and reduces the amount of interest by .25.

Home Equity Line of Credit (HELOCs)

A home equity line of credit is a revolving credit account. This works similarly to a credit card. You can borrow against your line of credit at any time, although some banks do require you to withdraw a minimum amount each time.

The unused funds in your credit line do not accrue interest. Most banks also offer fixed interest rates for a certain number of years after opening your line of credit.

Other Options

While an equity loan is a great option available to some people, it might not suit your needs. Many loans can help you with purchasing homes or renovations. These include first time home buying loans, reverse mortgages, refinancing, among a plethora of others.

Want to Know More

Now you understand what equity is and how a home equity loan works. We also learned alternatives and the pros and cons of each.

If you want more great content like this, check out the rest of our blog for more. Don't forget to share this one on social media with your friends and family as well.