Home equity loan

What’s a home equity loan?

In finance, equity is the difference between the valuation of an asset and the liabilities attached to it. If the valuation is higher than the liabilities, the equity is positive. If the liabilities are larger than the value, the equity is negative.

When you apply for a home equity loan, you offer the lender the equity (or part of the equity) in your home as collateral for the loan. If your application is approved and you go ahead and borrow the money, the equity will be reduced because a lien will be created against the home.

If you want to buy a home and take out a mortgage loan to pay for it, this is normally not referred to as a home equity loan, even though, if we want to be literal, it is. Instead, the term home equity loan is typically used when you already have a mortgage loan with your home as collateral but have some available equity and use that equity as collateral for a second loan. Because of this, the terms home equity loan and second mortgage (loan) are often used interchangeably.

Terms & Conditions

In general, the first mortgage loan (“bottom loan”) on a home will be longer term and have a lower interest rate than any other mortgage loan taken out while the initial mortgage loan still exist. This is because the first mortgage loan (“bottom loan”) is prioritized over the second mortgage loan if the borrower defaults and the home is sold through foreclosure. The lender with the bottom loan will be repaid first, and the other lender(s) will only be paid if there is any money from the sale left over after that.

Why use a home equity loan?

Since a home equity loan is secured debt, you can typically negotiate better terms and conditions for this loan compared to unsecured debt (e.g. credit cards and personal loans).

A home equity loan can be a great way of financing projects that will actually increase the market value of your home, such as renovations and add-ons. However, most lenders will not require that you use the money to finance home improvements. Home equity loans are used to finance a wide range of things, from traveling around the world to paying medical bills.

Fees

Examples of fees that you may have to pay in order to be approved for a home equity loan:

• Appraisal fee (to establish the current market value of your home)
• Originator fee
• Title fee
• Stamp duty

What is a HELOC?

HELOC = Home Equity Line of Credit

A HELOC is a line of credit where the home is used as collateral.

With a traditional home equity loan, you apply for a specific sum and if your loan application is approved the lender deposits that sum into your account. You then gradually pay back that sum in accordance with a fixed repayment plan.

A HELOC works differently. With a HELOC, you are approved for a specific credit amount, but you don’t have to use all of it. You can for instance be approved for a credit of $50,000 but elect to just take out $2,000 to pay for an emergency dentist visit.

Example:

1. Isabella is approved for a credit of $25,000. According to the terms and conditions, she only has to pay the interest each month; she doesn’t have to pay down the principal if she doesn’t want to – provided that the collateral is still valuable enough.
2. On July 5, Isabella needs to pay a few medical bills that are difficult to fit into her normal budget, so she gets $4,000 out of her HELOC. She now owns the lender $4,000 and have $21,000 left to use if she wish to.
3. When Isabella gets her next salary, she pays back $1,000 of the principal + the accrued interest. Her available credit is now $22,000. She didn’t have to pay down the principal, but she elected to do so.
4. The following month, Isabella realizes that the interest rate on an old credit card debt of hers has sky rocketed. Since the interest rate for her HELOC is much lower, she takes $2,500 from the HELOC to pay off the credit card debt in full. Her available credit from the HELOC is now $19,500. She only makes the minimum payment this month, which is the accrued interest on her HELOC debt.
5. October: Since Isabella is no longer paying exorbitant interest on her credit card debt, she uses that money to make an extra repayment to her HELOC instead of just paying the HELOC interest this month. Thereby, she is increasing her available credit.

As you can see, Isabella’s available credit will fluctuate up and down depending on how much of the credit space she has already used up. She has a revolving line of credit.

Getting a bigger HELOC

If you have used your HELOC in a responsible way for some time, you might get a notice from the lender, offering to increase your available line of credit. Due to your responsible use of your available credit, your creditworthiness in the eyes of the lender has increased and they are willing to let you borrow more than before.

How can I build positive home equity?

Positive home equity = the market value of the home exceeds the liabilities (debts).

Here area a few things you can do to increase home equity:

• Pay down debts for which the home is collateral.
• Do renovations and similar that increases the value of the home.
• Take exceptionally good care of your home. If your home is in better condition than similar homes in the area, your home will be more attractive to buyers and thus obtain a higher market price.
• Take steps to make the neighborhood more attractive to home buyers. The general attractiveness of the neighborhood will have a huge impact on home appraisals. Some factors will of course be beyond your scope to change, but there are also many factors that we as home owners can do something about – especially if we work together.

This article was last updated on: February 27, 2018