How Do Home Equity Loans Work?
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What They Are
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Home equity loans are just what the name implies: loans given to homeowners using equity from the home as security. Figuring equity is based on the difference between a home's assessed value and what is owed on the home. If the home has no mortgage, then the resulting equity is the total value of the home. Common types of home equity loans are home equity lines of credit (HELOCs) and traditional one-lump sum loans. A HELOC is a secured revolving line of credit that a customer can tap when he needs it, usually through checks. Being secured with home equity allows a bank to offer a lower rate than it would with more traditional lines of credit, such as credit cards. However, potentially risky variable rates are the norm with these loans.
Obtaining a Loan
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Obtaining a home equity loan is similar to getting a home purchase loan, particularly when the home is owned free and clear. Getting a home equity loan usually requires a credit check, an appraisal and income verification. The appraisal requirement is sometimes waived in the case of a recent previous appraisal. A home equity loan may be used to pay off liens or other mortgages. Taxes must be up to date or included in the loan. Determining eligibility, loan amount and interest rate is primarily a function of a customer's credit rating and the amount of equity compared to the appraised value of the home, or loan to value (LTV). To figure the LTV, divide the total amount of the loan by the home's assessed value.
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Repayment
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Repaying specifics of home equity loans varies depending on the type of loan. HELOC payments will almost always vary based on the outstanding balance and changes in the prime rate. A loan may have a rate of 1.5 percent plus prime, meaning the current rate is whatever the prime rate is plus 1.5 percent. Some home equity loans have prepayment penalties. The primary distinguishing feature and what makes home equity loans work is also what you must always be aware of--the loan is attached to your home. This means that no matter what you owe on the loan compared to the assessed value, the financial institution that made the home equity loan can repossess the home in the event of default.
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