A home equity loan is a great way to pay for renovations or to pay off other high interest rate debt like student loans or credit cards.
What is a Home Equity Loan?
A home equity loan, also known as second mortgage, allows the homeowner to borrow against the equity in their home.
When you take out a home equity loan you are borrowing money from the equity in your house, so essentially, you’re borrowing money from yourself. The interest rate and monthly payments on these types of loans are fixed so they are easy to plan and budget for.
How Do They Work?
In order to get approved for a home equity loan you need to have adequate equity in your primary residence. Most banks will allow you to borrow up to 85% of your home’s current market value.
Here is a simple example of how these loans work:
| Market Value of Home | $230,000 | Based on appraisal |
| Loan-to-Value | $195,500 | 85% of market value |
| Mortgage Balance | $175,500 | Left to pay |
| Home Equity Loan | $20,000 | Max amount you can borrow |
As you can see the amount you can borrow is simply the Loan-to-Value – Mortgage Balance. This calculation protects the banks by leaving enough equity in your home to cover both your first and second mortgage.
Is a Second Mortgage Right for You?
If you opt for a home equity loan you want to be smart about it. Home renovations and paying off high interest rate credit cards are two great reasons to apply for a home equity loan. Borrowing against your home’s equity to purchase a TV or pay for a vacation would not be a good use of your home equity loan.
Keep in mind, it is a loan, and you’ll have to make monthly payments to the the bank.
In addition to having adequate equity in your home (at least 20%) you should consider other factors in your decision when applying:
- Your credit score – this will determine what interest rate you pay
- Closing costs – can sometime be significant, consider how much you’ll pay up front
- Prepayment penalties – if you pay the loan off in 3-5 years there might be a penalty
Summary
A home equity loan is a great way to make home improvement or pay off higher interest rate loans. Just make sure you’re careful about how you spend the cash by either investing in something or paying down other debts. And whatever you do, don’t use the money to buy a home entertainment system or vacation for the family!