How Home Equity Credit Works
Home equity credit allows homeowners to borrow money using their home as collateral for the loan. This means that the lender for the home equity credit holds a lien on the home, and has the right to pursue repayment of the loan through the sale of the home if the borrower fails to pay back the loan. Home equity credit can be an inexpensive way to obtain money for a variety of purposes.
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Types
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Lenders offer home equity credit in two major forms. A home equity line of credit works similar to a credit card, in that the borrower has a line of credit and can borrow from that line of credit at any time. When the borrower reaches the credit limit, he has to make payments to free up credit before making more purchases with the line of credit. A home equity loan, on the other hand, provides the homeowner with a lump sum of money when he takes out the loan.
Repayment
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Borrowers repay their home equity loans or lines of credit over a period of time dictated by the lender. Home equity loans typically are installment loans, meaning that they are repaid over a set period of time with an equal payment amount each month, like a car loan or a traditional mortgage. Home equity lines of credit often require interest payments only at first. However, after the draw period is over, the homeowner cannot borrow from the line of credit anymore and must switch to making larger payments. Some home equity lines of credit require a full payment at the end of the draw period, whereas others allow for an installment schedule.
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Amount
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The maximum amount of home equity credit a homeowner can obtain depends on a few factors. First, lenders typically do not allow homeowners to borrow more than 80 percent of the current value of the home. The 80 percent includes the mortgage. Therefore, the maximum home equity credit is typically the home value times 0.8, minus the amount owed on the mortgage. Lenders also look at the homeowner's overall monthly payments for all kinds of debt in comparison to overall monthly income. Debt payments should be no more than 36 percent of income, so lenders cap equity credit at an amount that keeps total payments under 36 percent. In addition, lenders require a credit check before approving a home equity loan or line of credit.
Considerations
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Home equity credit typically comes with a lower interest rate than personal loans, and can be used for any purpose, making it a useful source of credit for homeowners. Some of its most common uses include making home improvements, consolidating other types of debt, paying education expenses, paying medical bills and financing big-ticket items. However, homeowners should be careful when taking out home equity credit because failure to make payments could result in loss of the home. Homeowners should not borrow more than they can reasonably expect to be able to pay back. In addition, lenders require full repayment of a loan or line of credit when the house is sold, so homeowners should not take out a loan if they cannot afford to repay it when they plan to sell the house.
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