A home equity loan is a type of loan in which the borrower uses the equity of the home as collateral. The loan amount is dictated by the value of the property, which is generally determined by a licensed appraiser, along with the balance on the current mortgage. Home equity loans are often used to finance major expenses such a home repairs, medical bills or college education. A home equity loan creates a lien against the borrower’s house and reduces actual home equity.
Home equity loans come in two types: A traditional home equity loan (closed end) and a home equity line of credit (open end). Both are referred to as second mortgages because they are secured against the value of the property, just like a traditional mortgage. They may provide access to large amounts of money and may be easier to qualify for than other types of personal loans because they are secured by your house.
Traditional Home Equity Loan: If funds are for a known major purchase like a home improvement, than taking a lump sum to pay it off immediately makes sense. Monthly payments will start the next month at a consistent rate throughout the term of the loan.
HELOC Loan: If funds are needed for a short period of time and will be repaid quickly, then HELOC makes sense. The initial HELOC variable rate will likely be less than a traditional fixed-rate Home Equity Loan, so interest costs will be lower. If flexibility is important, HELOC is your best bet. Funds can be withdrawn and repaid many times during the life of the loan. This may appeal to self-employed borrowers whose income varies and may need short-term cash to balance their income.
Most Home Equity loans require good to excellent credit history and reasonable home loan-to-value ratios. Generally, a minimum credit score of 620 is required for approval.
The loan-to-value ratio depends on the type of property and how you use it. For a primary, single-family home the loan-to-value can be as high as 90% (mortgage amount + home equity amount divided by the home value). Condos and second homes are typically limited to 80% loan-to-value.
As with most loans, your income must be verified and your income along with other liabilities will be taken into account to determine your ability to repay the loan in full.
With either a home equity loan or a line of credit, you’re pledging your home as collateral, meaning if you don’t make payments on your loan the lender could end up owning your home. Equity loans and lines of credit often have a repayment period of 15 years, although it might be as short as five and as long as 30 years. Even if you end up selling your house, you still have to pay off the balance of the loan before the title can be transferred.