Home Equity Loans

Home Equity Loans

To understand what a home equity loan is, it is necessary to understand the definitions of the following terms.
 
Collateral: When a property is pledged as a guarantee for borrowing money, the property is called as collateral. If the borrower fails to repay the money, the property pledged may be taken by the lender.

Equity: It is the difference between the value of the property and the balance mortgage one owes.

For example, if the value of a property (home) on the day of purchase is $220,000 and assuming that a down payment of $20,000 is made and the balance amount $ 200,000 is taken as mortgage, the equity on the day of purchase is $20,000.

After two years, assuming the value of the property is increased to $235, 000 and a monthly payment towards the principal amount is $10,000 is made. The value of the mortgage after deducting the monthly payments towards principal is $190,000. So, the equity value becomes $45,000. 

A tabular format of the above example has been provided for better understanding.

Initial value of equity,

Value of the property on the day of purchase	$220,000
Down payment	$20,000
Amount taken as mortgage	$200,000
Equity (Value of property – mortgage)	$20,000

After two years,

Amount taken as mortgage	$200,000
Amount paid as towards principal	$10,000
Current Mortgage value	$190,000

Value of the property after 2 years	$235,000
Equity (Value of property – mortgage)	$45,000

Home Equity Loan
To get a loan using the equity as collateral is known as home equity loan. The home equity loan is otherwise called as second mortgage as it is obtained based on the value of the property.

 

Home equity loans are usually taken for

• Renovation
• Purchase of  property
• Purchase of automobiles
• Pay off for credit cards with high interest rates
• Educational purposes
• Investing in another business
• Medical needs

When applying for a home equity loans the lenders charge the customers with some fees and closing costs. The fees charged covers property appraisal, application, document preparation and attorneys.

For sanctioning the loan, the lenders look for credit history, income and the LTV ratio of the borrower.

Credit history
The credit history provides the lender with the following information

• Personal information of the borrower that includes name, address etc.,
• The amount owed, credit limits, also whether the bills have been paid on time
• It also provides them with public records such as bankruptcies, foreclosures, legal proceedings etc.,

Income
The lenders will sanction the loan based on the income derived by the borrower as that decides whether the loan can be paid successfully.

LTV ratio
The LTV ratio is defined as the money borrowed divided by the value of the property. The borrower can borrow up to 80% LTV (loan-to-value) ratio in home equity loans. For example, if the value of the property is $100,000 and the mortgage value is $50,000. The current LTV ratio is 50%. So the amount that can be borrowed as home equity loan is $ 30,000. The total loan value after adding the home equity loan is $80,000 ($50,000 + $30,000). Now the LTV ratio of 80% is obtained by dividing total loan value by the property value gives.

Types of home loan equity
There are two types of home equity loans. They are

• Home equity loans with fixed rate or fixed rate loans
• Home equity line of credit (HELOC)

Home equity loans with fixed rate or fixed rate loans: In this type of loan, the bank provides a complete payment to the borrower that has to be paid over a period of time at a fixed interest rate. The amount and the rate of interest remains the same till the debt is paid.

Home equity line of credit (HELOC): This type of loan acts similar to a credit card that is the borrower will be approved certain amount of credit that can be withdrawn whenever needed via a credit card or special cheques.  The payments are calculated based on the current rate of interest and the amount that has been withdrawn for the month. Hence, the amount and the rate of interest vary till the debt is paid.

Advantages of home equity loans

Borrowers

• Lower rate of interest when compared to other type of loans
• Better chance of approval as they are based on credit score
• The interest paid in home equities are tax deductible

Lenders

• The property is the most secure asset

Disadvantages of home equity loans
As the property has been pledged as collateral if the borrower fails to repay the loan the property is taken by the lender.

Steps to be taken to obtain the right home equity loan

• Search for the best lender in the market
• Compare the annual percentage rate (APR) offered by each lender
• In addition to APR, compare the broker fees and the credit charges that are charged by the lenders
• Enquire about the length of the loan
• Enquire on monthly payment whether it will remain the same or is it liable to change
• Check for balloon payments. A balloon payment is a big payment paid at the end after the low monthly payments.
• Enquire about prepayment penalty. Prepayment penalty is the amount that must be paid if the borrower is paying off the loan before the term finishes.    

Fixed rate loans Vs Home Equity line of credit

	Fixed rate loans	Home Equity line of credit
Payment type	Monthly payments are fixed	Monthly payments vary
Interest rates	Interest rates are fixed	Variable rate of interest
Amount	Borrower receives a lump-sum amount from the lender	Borrower may withdraw the desired amount