What is a Home Equity Loan?

By Eleanor Alexander on March, 29 2018
Eleanor Alexander
Eleanor Alexander

Eleanor is a copywriter, creative, and mac and cheese enthusiast. 

First things first. Before you can understand home equity loans, you have to understand home equity, then you can get to the different types of home equity loans.

So, what is home equity? 
Justin Pritchard from The Balance writes, “To calculate equity, subtract any outstanding loan balances from the property’s market value. Home equity can increase over time if the property value increases or the loan balance is paid down.”

For example, say you buy a home for $200,000. You put 20% down, or $40,000 and borrow the remaining $160,000. A few years down the road your home is appraised and it has increased in value to $250,000. You’ve also been paying down your mortgage and now own $150,000. Your home equity is the difference between how much the home is worth and how much you owe.

A home equity loan is often a second mortgage. They offer access to a large amount of money and because they are secured by your house, are easier to qualify for than other types of loans. There are two types of home equity loans, term loans and lines of credit.

Term Loan

Also known as a closed-end loan or a lump-sum. You take a one-time loan and receive a large amount of cash upfront. Your interest rate is fixed and you make the same payment every month until the loan is paid off.

Line of Credit

Often known as a HELOC which is short for home equity line of credit. With a line of credit, you get approved for the maximum amount available and borrow as you go.

Unlike a term loan, where you have to reapply to borrow more (unless you’ve borrowed the full amount the first time), a line of credit allows you to borrow multiples after you’ve been approved. In that sense, it works a bit like a credit card. You can borrow up to a certain amount for a certain amount of time. The life of the loan will be set by the lender.

During this borrowing period, also known as the draw period, you might make some smaller payments. But when the draw period ends you have to start making regular payments on the loan.

Unlike a term loan, a line of credit has a variable interest which will fluctuate. Your payments will depend on the interest rate and how much credit you’ve used.

Benefits for Borrowers

Home equity loans are an easy source of money for borrowers. Interest rates are typically lower than rates on credit cards or other consumer loans. On that note, the number one reason consumers take out a home equity loan is to pay off their credit card. And although approval is not guaranteed, home equity loans are easier to qualify for than other loans, which can be helpful if you have bad credit.

Benefits for Lenders

A home equity loan is a relatively safe loan for lenders, which is why it’s easier to qualify for. The loan is secured by your house as collateral, so even if you fail to repay the loan, the bank can take your property and sell it, recovering any unpaid money. Borrowers will often prioritize this loan over others because they don’t want to lose their homes.

Making a Decision

Should you take out a home equity loan? It depends on your situation. While the money can be used for virtually anything, it makes sense only to take it out for important or costly expenses. Home improvements, paying for college, starting a business, or medical bills are all common reasons for home equity loans.

They can be a valuable tool for responsible homeowners but an easy pitfall for people who like to spend. If you are at a stable point in your life with a reliable income and know you can repay the loan, this may be a sensible option for you to consider.

We may be getting ahead of ourselves here - before you can take out a home equity loan you need to get your perfect home, and to do that, you need to be able to afford the down payment. So continue reading here for tips on how to save for a down payment.