House sitting next to money from a home equity loan

How Does A Home Equity Loan Work?

Are you a homeowner looking to free up some cash for a remodeling project? If so, you may be the perfect candidate for a home equity loan. Home equity loans are one of several benefits of being a homeowner. If you don’t know how they work, they seem like a confusing source of free money. That’s not quite it. We’ve got the real explanation here.

What is a Home Equity Loan?

A home equity loan is a type of mortgage loan that’s based on the value or equity of your home. Also referred to as second mortgages, these loans are particularly beneficial if you owe little or nothing on your mortgage because they can provide you with extra cash that doesn’t need to be repaid immediately. You can use the money for whatever you wish.

How Do They Work?

Home equity loans are based on the value of your home and any amount you may owe on your first mortgage. In most cases, the lender will allow you to borrow around 80% to 85% of the value of your home. However, some may allow a loan-to-value (LTV) of up to 100% of the home’s value.

Here’s an example of how the math side of a home equity loan works. Let’s say you have a home that’s valued at $200,000 and still owe $75,000 on the original mortgage. Using the 80% guideline, you would be able to borrow up $160,000. Because you already owe $75,000, this amount is deducted from the $160,000. Based on these figures, you could get a home equity loan for up to $85,000. We got that by taking $200,000 X .80 to get $160,000, then subtracting $75,000 and ending up with $85,000.

Pros and Cons

Home equity loans can provide you with extra cash you can use however you desire, but they’re especially good to use for projects that add equity back into your home. The interest rate of home equity loans is usually lower than on unsecured or consumer loans, which makes them tempting credit sources for everyday purchases. Many consumers who have a lot of equity in their homes choose home equity loans for large purchases because of the lower interest rates and the ability to deduct the interest.

While there are not a lot of disadvantages to home equity loans, there is one. Because home equity loans are often a second mortgage, you have no additional equity in your home. If you fall into hard times and can’t make payments, you could lose your home.

What Are the Requirements?

The eligibility for a home equity loan is very similar to a conventional mortgage. You need to have a home that has the value or equity you need. You must also have good credit and be able to show proof that you’re financially able to pay off the loan. There are some cases, however, where homeowners take out a home equity loan to help pay off other debts and improve their credit. 

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