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What is a home equity loan and how does it work?
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What is a home equity loan and how does it work?

What is a home equity loan and how does it work?

A home equity loan lets you borrow money using the equity you have in your home as collateral. If you're like many homeowners, you may have earned a meaningful amount of equity over the years. And while it certainly feels great to know your real estate investment has increased in value, equity could help you reach your financial goals. For example, tapping your home equity can enable you to complete a dream renovation — which may also add value to your home. Using your equity, you could also pay off high-interest debt or cover other major expenses.

There's more than one way to tap the equity in your home; this article focuses on home equity loans, which are different from home equity lines of credit (HELOC).

What is a home equity loan?

A home equity loan is type of loan that is secured by your home, that is, you are putting your house up as collateral. Because they are secured, these loans typically have fixed interest rates that are lower than those of an unsecured loan, such as a credit card or a personal loan, but it also means falling behind on your payments could mean the loss of your home. Funds are distributed in one lump sum with repayment terms that range from five to 30 years.

Taking out a home equity loan (HEL) can be a good idea if you are in need of a lump sum of money, as it allows you to take advantage of the equity in your home to access additional funds. For example, if your home is valued at $200,000 and your mortgage balance is $150,000, then you have $50,000 worth of equity that you could use with a home equity loan. Generally speaking, this type loan will have a fixed interest rate meaning the amount of the payment that go toward interest won’t change over time.

Taking out a home equity loan requires caution because you risk losing your home to foreclosure if you can't make payments on both your original mortgage and the home equity loan. Experts at the Consumer Financial Protection Bureau recommend seeking advice from a credit counselor before getting a home equity loan to make sure it is the best option for you. Always make sure to understand any fees and costs, such as application fees, closing costs, and appraisal costs associated with loan and how that will impact your monthly payments.

How a home equity loan works

A home equity loan is a second mortgage on your home, with the equity in your home being the collateral on the loan. Home equity loans are attractive options for borrowers because they typically involve lower rates than other types of financing and can be used for many purposes, such as debt consolidation or home improvements. The amount that a homeowner is allowed to borrow with a home equity loan usually translates to an 80-90% combined loan-to-value (CLTV) ratio based on the appraised value of the home. The interest rate will also depend on factors like credit score, payment history, and borrowing terms. 

Most homeowners use home equity loans to pay for a large home improvement project, many of which can raise the resale value of the home. And, if the loan is used for home improvement, the interest paid may be tax deductible in certain circumstances, but you should consult a tax advisor regarding the deductibility of interest and charges. You can also use the funds for debt consolidation, to make a major purchase, or manage an unforeseen financial emergency.

How much can you borrow with a home equity loan?

How much you can borrow with a home equity loan depends on the value of your home and how much you owe on your home, or your combined loan to value (CLTV) ratio. Lenders look for a maximum CLTV between 75-85% of the home value. For example, if your home value is $400,000, with a maximum CLTV of 80% the most you could borrow would be 80% of $400,00, or $320,000. If you currently owe $250,000 on your primary mortgage, you must subtract that from the total amount. So, $320,000 - $250,000 = $80,000, so this is the maximum amount you would receive in a home equity loan. The formula is (Home Value x CLTV) - (total current debts on the property).

How long does it take to receive funds from a home equity loan?

It can take up to six weeks to complete the entire application and approval process.

The typical home equity loan application process requires verification of documents related to your income and debts, an assessment of your home's value by an appraiser, and verification of property ownership documents, such as tax assessments and mortgage statements. It can take as long as four to six weeks to complete the entire process and gain access to the funds.

How much does a home equity loan cost?

You can expect to pay 3-6% of the loan amount in fees.

There are generally costs associated with taking out a home equity loan, which typically equals about 3-6% of the loan amount. Commonly, you'll pay an application fee, an appraisal fee, and closing costs to cover attorney fees, title searches, title insurance, and taxes. In addition, some lenders will charge prepayment penalties if you pay off the loan during its early years. It's important to understand the exact costs, fees, and terms associated with the home equity loan you are considering before finalizing the loan. 

How are home equity loan funds disbursed?

You'll receive the money in one lump sum and repay it with fixed monthly payments.

Funds are disbursed in one lump sum, usually directly to your checking or savings account. Since most home equity loans have a fixed interest rate, you'll repay the principal and interest owed via equal monthly payments over the term of the loan. For example, if your total loan amount is $100,000 at a fixed interest rate of 7% over a five-year term, your monthly payment would be $1,980.

What is the difference between a home equity loan and a home equity line of credit (HELOC)?

If you've heard of home equity lines of credit (HELOCs), you might be wondering how it compares to a traditional home equity loan. The primary differences are in how you get your funds and the interest rate.

Home Equity Loan: Funds disperse in one lump sum, Typically has a fixed-interest rate

HELOC: Funds dispersed in periodic "draws" against your credit limit, Typically has a variable interest rate

Home equity loans are a popular way for homeowners to borrow against the value of their home. They provide a lump-sum payment to the borrower that must be repaid in full if the home is sold, usually over a period of five to 15 years at an agreed-upon interest rate. The primary benefit of home equity loans is that they offer predictable payments and interest rates since they remain fixed over the lifetime of the loan. This makes it easy for homeowners to plan financially, as they know exactly what their payments will be and when they will be due.

In contrast, Home Equity Line of Credit (HELOCs) works more like a credit card than an ordinary loan. HELOCs offer borrowers access to a set amount of money that can be used however they see fit. Unlike home equity loans, with HELOCs, borrowers can choose how much or how little they pay each month based on their current financial situation, making them ideal for short-term needs or ongoing spending needs. HELOCs also have adjustable interest rates fluctuating with market conditions, meaning borrowers won’t necessarily know what their costs will be until closer to the end of repayment.

Pros and Cons of Home Equity Loans

There are advantages and disadvantages to home equity loans. As with any type of borrowing, it comes with risk and is not a decision to be taken lightly. 

Pros of Getting a Home Equity Loan

Home equity loans can be a great tool for responsible borrowers. One of the main advantages is that it is a secured loan and thus, is quite simple to obtain for many consumers. The lender performs a credit check and orders an appraisal of the borrower's home to determine their creditworthiness and CLTV (Combined Loan-To-Value). Also, the interest rate on a home equity loan tends to be significantly lower than that of credit cards and other consumer loans. That helps explain why one of the primary reasons people borrow against their own homes via these fixed-rate home equity loans is to pay off their outstanding debts such as credit card balances.

Another advantage of opting for this kind of loan is the potential tax deductions. Although interest rates on home equity loans are higher than first mortgage rates, they are still much lower than those applicable in consumer finance industries. This makes them more attractive to those looking to access liquid funds with an acceptable rate of interest while simultaneously using any tax benefits they may be eligible for. Thus, if you have a steady source of income and confidence you'll be able to repay the loan easily, then low-interest rates combined with potential tax deductions make it a sensible choice!

Cons of Getting a Home Equity Loan

Home equity loans can seem like an easy solution for people who may have fallen into a cycle of borrowing and spending that keeps them deeper in debt. This is known as “reloading” and it can be expensive: lenders often charge higher fees because the loan is not completely covered by collateral. Additionally, the portion of the home equity loan that exceeds the value of the house may not be tax deductible, which means more costs for the borrower.

The risk with taking out a home equity loan is that it is easy to borrow more than you need at the time in case you might require additional money in the future. While this could prove to be beneficial, it also runs the risk of giving borrowers access to too much money which they cannot afford to pay back on their own. It can quickly become difficult to keep up with payments if you are about to take out a larger amount than originally anticipated.

A smarter way to borrow against the equity in your home.

At Figure, our Home Equity Line of Credit has a fixed interest rate1navigates to numbered disclaimer and gives you full access to your funds up front, while also enabling you to access additional funds once you start to pay down your original disbursement. Plus, we only charge an origination fee2navigates to numbered disclaimer, and you'll be able to access the full amount of your loan in as few as 5 days3navigates to numbered disclaimer. Learn more about Figure Home Equity Line and see if it could be a good fit for your financial goals.

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