After you’ve been paying for your home mortgage for a couple of years, there are times when you have a pressing need for cash, and you don’t know where you’d be able to get the money. A lot of Americans don’t know they can borrow off their equity. The money that you paid on your home mortgage loan thus far is called your equity. A loan which you take from your equity is called a home equity loan.
Aside from commercial banks and lending institutions, there are numerous federal credit unions across the United States that offer home equity loans. But, you’ll have to wait for a bit longer than when you borrow from the bank. Getting a home equity loan is one of your options if you’ve already paid up a number of years on your home mortgage loan. Yes, you might not have realized it, but your equity is an asset you can borrow from.
A Second Mortgage
A home equity loan is a type of consumer loan or consumer debt. Basically, a home equity loan provides a way for the homeowner to borrow some cash from the payments they’ve already made to their current home mortgage loan. Sometimes, these are also called a second mortgage, an equity installment loan, or, simply, an equity loan.
The homeowners would be allowed to borrow some cash out of the portion of the home mortgage loan they’ve already paid. To calculate the loan amount, the difference between the balance due on the original home mortgage loan and the property’s current market value is computed. The difference is the amount that the homeowner can borrow.
Typically, home equity loans are charged a fixed rate interest. The usual alternative loan product, which is called Home Equity Lines of Credit (HELOC), is charged variable rates most of the time.
How Equity Loan Works
The basic idea behind a home equity loan is that the homeowner should be allowed to take out a second mortgage based on the payments made on the original or current home mortgage loan. The total amount already paid is called equity. It serves as the collateral of the borrower for the loan extended by the lender.
Generally, the formula used in a home equity loan is partially based on what’s called a Combined Loan-to-Value (CLTV) ratio. The loan amount that the homeowner would be allowed to borrow will be based on a CLTV ratio of 80% to 90% of the appraised value of the home used as collateral in the original home mortgage loan.
But, the credit score of the borrower, as well as payment history, will be factored in by the lenders when they calculate the amount of the loan as well as the rate of interest to be charged on the loan.
Advantages And Disadvantages
One advantage of getting a home equity loan is that it’s relatively easy to obtain. It's an easy source of cash. It’s one kind of loan which you can get if you’ve already paid a substantial sum of money on your home mortgage.
A home equity loan is one of your viable options if you have a steady and regular source of income, and you can fairly forecast that you can repay the loan within the term given. An additional advantage of getting a home equity loan is that it usually has lower interest rates compared with other loans because it’s a secured loan.
The interest rates on home equity loans are relatively low. They’re a bit higher than the interest rate charged on the original home mortgage loan. But, they usually have interest rates lower than those charged by credit cards and other consumer loans.
Another advantage of a home equity loan is that it's tax deductible to the extent of the value of your home because it’s still a mortgage.
The main disadvantage of a home equity loan also has something to do with the fact that you can easily get one. Some borrowers, when they find themselves sunk deep into debt, sometimes, see a home equity loan as the easiest and fastest solution to their financial woes.
But, if they use the loan proceeds to spend on non-essential or even luxury expenses, they’d plunge themselves deeper into debt. It becomes a vicious cycle of spending, borrowing, overspending, and then borrowing some more. The problem becomes alarming when the person gets mired in the habit of borrowing more money just to pay off existing debts.
There are even some lenders who offer home equity loans which would allow the borrower to take up to 125% off their equity. This offer can be very tempting to some who think they’re getting a very good deal because they’re receiving more than they’ve already paid on their mortgage.
Borrow Only What You Need
A home equity loan is a convenient option if you need some cash, but be reminded to borrow only what you need because loans are charged interest rates. If you’re borrowing only to spend on non-essential things, then you might be burdening yourself with unnecessary debt.