Defining Home Equity Loans – What is a Home Equity Loan & How Does it Work?

A home equity loan is a suitable option for borrowers because it provides a comparatively higher principal amount with a lower interest rate and tax deduction. But, a home equity loan is deemed riskier for the consumer, as the loan is secured by the lien on borrower’s property and any default can result in a foreclosure of the property. So, it is always good to take extra precautions after taking out a home equity loan.

A home equity loan can be used for any big expense: home improvement and renovation, medical expenses, tuition fees, and so on. Often, a home equity loan can be utilized to pay off any unsecured debt (e. g, credit card debt) or that has a higher rate of interest. Normally, unsecured debt comes with a higher rate than a secured one because if the borrower goes bankrupt, the unsecured creditors cannot demand payment of their debts.

The amount of credit that one can borrow from a home equity loan depends upon the current market value as well as the equity of the property. The market value fluctuates often and a home or real estate appraisal can ideally reveal the proper value of the property by accounting for different factors, e.g., the amount and type of the assets and the current market value of the neighboring properties for similar category assets. In order to determine the property value without the help of a home appraiser, a comparison with similar category properties that have recently been sold in the local real estate market may be sufficient. There are free tools online to determine home value and to find comparable sales online. However, prior to the loan approval, your lender will require an appraisal of your home by an independent appraiser who can give the most accurate information about the proper value of the home.

Lenders normally approve a loan based upon the home’s equity, not the overall value of the property. A home’s equity can be calculated by deducting your owed balance from the appraised value of the home. So, if your property value increases, your home equity increases as well. Similarly, if you pay some of your loan’s principal, your home equity will rise. Another way to improve your home equity is by renovating or improving your home. In the case of home equity, the opposite thing can also happen, i. e. if the property value decreases due to a market crash or any other reason, you can have negative equity, in which case you owe more than the current value of your property.

Another way to utilize your home equity is to obtain a home equity line of credit. A home equity line of credit is like a credit card which has a fixed limit. This limit is identified by the lender based upon the equity of the home. The borrower can borrow any amount within the set limit whenever they want. A line of credit is suitable for home improvement and renovation, tuition fees and other large expenditures.

If you need a loan in a particular amount for a specific purpose, a cash-out refinancing or a second mortgage may be appropriate. In cash-out refinancing, you take a larger mortgage to pay off your existing mortgage and the extra amount is cashed out, which can be utilized for any other purpose of your choosing.

Before you select a home equity loan or refinance your mortgage, you need to understand how the loan can be customized for your purposes and the terms and conditions of the loan, monthly payments, prepayment penalty and processing fees, and so forth.

Benefits of Home Equity Loans vs. Personal Loans

Home equity loans are a type of financing secured by property; meaning, failure to repay the loan could mean the loss of your home. Since a loan secured by a home presents less risk to the lender, home equity loans typically result in better benefits for the borrower. There are many reasons to choose a home equity loan over an unsecured personal loan. Tapping into your home’s equity may provide:

●      Higher Credit Amounts

●      Lower Interest Rates

●      Tax Deductions

When a lender has fewer associated risks — and since equity that has accumulated in your home could be quite large — lenders are more likely to offer larger credit amounts compared to personal credit lines. Also, the interest rate on a home equity loan is often lower than any other type of non-secured debt. Not only are the interest rates lower, but they can usually be deducted on your taxes.

You can use the benefits of a home equity loan for almost anything. Some examples include home improvements, large purchases, and medical expenses to name a few. In fact, it is very common to use a home equity loan to pay off high-interest debts on unsecured loans. Consolidating several higher-interest credit accounts into one can be a good idea when it lowers your overall rates and provides tax benefits. While the benefits of home equity loans can be very significant, it’s important to remember that your home can be taken if you default on the loan. Therefore, spend the money wisely by making sure you can afford to pay it back.

Determining the Market Value of Your Home

The amount of credit from a home equity loan will depend on several factors. The first step is to determine the current market value of your home, and the second involves calculating the amount of equity you have in your home.

Determining the market value of your home requires a bit of research since fluctuations in the housing market have proven that property values can shift – ideally upwards, but not always. The best place to start your home’s valuation is to research your neighborhood’s existing home sales. Searching real estate listings online and visiting open houses in your neighborhood can provide a general survey of your local real estate market. Comparing homes similar in size and features to your own is important when estimating the market value of your home.

There are several free tools that allow you to search home values and comparable sales online. These features can be found on many real estate websites, including eppraisal and Zillow. On their sites, you can view an estimate of your home’s value as well as other homes in your area. The ability to search homes that have sold in your local area is another helpful tool offered by these websites for determining the market value of your home.

The internet is a great resource when determining the market value of your home. However, an independent appraisal by a professional is typically required by the lender in order to assess your home’s equity. This will give you the most accurate results and is always good information to have.

Determining How Much Equity is in Your Home

To calculate the equity in your home, take the market value of your home and subtract the balance owed.

With a home equity loan, you will be approved for a qualified amount of credit based on this calculation. For example:

Appraised value of home   = $200,000

Minus the balance owed =$50,000

Home equity           =$150,000

The amount of equity in your home can change based on your home’s value and the terms of your mortgage. To increase your home’s equity, pay more towards the principal and shorten the terms of your mortgage. Once your home is paid off, you own 100 percent of it. Home improvements are another way to increase your home’s equity, but don’t overdo it.

If property values in your area increase, so will your equity. However, while houses tend to appreciate over time, it is possible for property values to decline. The result is a decrease in your home’s equity. If the value decreases and you have an interest-only mortgage, you could end up owing more than the house is worth. To avoid this, make sure that some of your mortgage payments are paying down the principal and try to buy a home in an area where property values are increasing.

How Home Equity Loans are Used

A home equity loan provides you with a fixed amount of money, repayable over a fixed period of time. If you need money for any expenses, a home equity plan is a good option that might be right for you. Before making a decision, however, you should shop for the credit terms that best meet your borrowing needs without posing any financial risks.

Home equity loans are utilized in countless ways. The most common uses for home equity loans include home renovations, tuition, credit card consolidation, medical expenses, and other major expenses.

Your home is likely your most valuable asset and a home equity loan is great way to cash out some equity; however, be aware that the market can change. A home equity loan is paid off – along with your first mortgage — through monthly payments. When you sell the house, the balance of both the loan and the mortgage must be paid.

How Home Equity Loans are Obtained and Calculated

Home equity loans can be obtained in a lump sum or used as a home equity line of credit. Homeowners who require a large amount of money to pay expenses go with the home equity loan. This loan can be either a fixed rate mortgage or an adjustable rate mortgage.

With a home equity line of credit, you will be approved for a specific amount of credit. Once approved for a home equity line of credit, you can borrow up to your credit limit whenever you want. The amount of equity credit is typically calculated by taking a percentage of the home’s appraised value and subtracting from that the balance owed on the existing mortgage. For example:

Appraised value of home=$200,000


Percentage of Appraisal=$150,000

Minus the balance owed=$50,000

Potential line of credit=$100,000

You might consider a second mortgage instead of a home equity line of credit if you need a set amount for a specific purpose, such as remodeling your home. A traditional second mortgage provides you with a fixed amount of money, repayable over a fixed period. In most cases, the payment schedule calls for set payments that pay off the entire loan within the loan period.

Cash-out refinancing is not a home equity loan,but it does let you borrow against your home’s equity. In cash-out refinancing, you refinance the existing mortgage with a new one. The new mortgage includes your existing debts plus extra funds which are borrowed against your equity. Essentially, you refinance your first mortgage for a larger amount and take the difference in cash. For example:

Appraised Home Value= $200,000

Owed on 1st Mortgage = $100,000

New Mortgage= $170,000

Pay Original Mortgage= $100,000

Cash Out= $50,000

Remaining Equity= $20,000

Who Should Take Out a Home Equity Loan?

Due to the lower interest rates and tax benefits, a home equity loan is a great way to manage your expenses. If you are having trouble managing credit card debt or other major expenses, a fixed-rate home equity loan allows you to pay off your debts with one predictable monthly payment. Consolidating debts that carry a high interest rate, such as outstanding credit card balances, can help tremendously. You will also save money on interest with lower rates and tax deductions.

For anyone looking to enhance the value of their home, home improvement projects are a good use for a home equity line of credit. However, make sure your improvements don’t go over the value of your home.

If you decide to apply for a home equity line of credit, look for a plan that best meets your individual needs. Consider how you will pay back the money before entering into a plan. When you sell your home, you will be required to pay off your home equity line in full immediately. Thus, if you are likely to sell your home in the near future, consider whether it makes sense to pay the up-front costs of setting up a line of credit.

10 Questions You Should Ask Yourself Before Taking Out a Home Equity Loan?

Before you enter into a home equity loan, it’s important to understand how they work. Here are 10 questions to ask your loan officer:

1.     How much can be borrowed? Lenders will have different methods of calculating your credit.

2.     What is the term of the loan? This will determine how long you have to repay your loan.

3.     What is the interest rate? Is it fixed or adjustable? With a fixed-rate loan, the interest remains the same throughout the term of the loan. An adjustable-rate loan has interest rates that will be adjusted periodically according to general interest rates. Determine if there is a cap on the adjustable rate.

4.     How much will my monthly payment be? Know your limits before taking a loan. Establish a monthly budget to learn what you can afford.

5.     Will there be a balloon payment due at the end of the term? If so, be prepared to pay a large payment when the loan is over.

6.     Is there a penalty if I pay off the loan before the end of the term? Some lenders will charge you a fee if you pay off your loan before the term is over.

7.     What are the fees associated with the loan? You may be expected to pay some fees associated with processing your information and closing the loan.

8.     Under what circumstances can the lender call the loan? If you fail to make payments, some lenders will demand that you pay off the loan early.

9.     What documentation do I need to provide? You will need to submit information about your employment history, as well as your assets and other debts.

10.  When will I receive the funds? It may take a while to process your information, so your loan may not be available immediately.

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