Updated on October 22, 2021
Have you ever wondered how you can pay for large expenses like a home remodel or child’s college education? Many individuals use a home equity loan to cover these costs instead of depleting their savings.
If you own a home, you could qualify for a home equity loan. These loans can help you finance things you may not be able to buy comfortably with your monthly salary. But are there any limitations on these loans? Is there anything you can’t finance with this money? Read on to learn what a home equity loan is and what you can use it for.
What is Home Equity?
Home equity is the difference between the appraised value of your home and how much you still owe on your mortgage and any other property liens. For example, say your house appraises for $200,000 and you have $120,000 left to pay on your primary mortgage. Your remaining home equity would be $80,000. You can use a home equity loan to borrow against a percentage of the equity you have in your home.
What is a Home Equity Loan?
The amount you may borrow depends on your equity and the home’s market value. You use your home as collateral for the loan, and if you have a first mortgage on the home, it’s subordinate to that first mortgage. This is why home equity loans are often called second mortgages.
Your loan will have a set term and interest rate, much like your first mortgage. If you get a home equity loan, you’ll get your money in one lump sum up front and usually get a fixed rate on what you borrow.
By contrast, a home equity line of credit (HELOC) allows you to draw on the line of credit as you need it, giving you revolving access to cash for a set draw period. Your payment is then based on the amount of money you transferred or “advanced.” With a HELOC, you’ll likely get a variable rate that goes up or down depending on the prime rate.
How Does a Home Equity Loan Work?
To qualify applicants for a home equity loan, most lenders require a good credit history. They’ll also consider your loan-to-value (LTV) ratio, which is the total amount of mortgages or other liens on your property divided by its appraised value. This amount is then multiplied by 100 to be expressed as a percentage.
For example, say our $200K homeowner who had $120K left to pay on their home wanted a loan of $30K. The LTV ratio would be: ($120K + $30K)/$200K = .75. So, the LTV would be 75%. The higher your LTV, the higher your interest rate may be.
It’s important to note that you may not be able to borrow the full value of your home, depending on your lender. You should check with any potential lender prior to submitting your application to see what limitations they have in place.
As with any mortgage, there may be closing costs associated with a home equity loan, though they’re typically lower than a first mortgage. You begin to pay back a home equity loan immediately and must repay it in full by the end of the loan term.
Why Get a Home Equity Loan?
There are some advantages to choosing a home equity loan instead of another type of borrowing option. A couple of them are listed below.
- Low interest rates. The rates you’ll find for a home equity loan usually fall below those you’ll be offered on a personal loan or credit card.
- Larger sums. Most home equity loans are for substantial sums of money – much more than a few hundred or even a couple thousand dollars. It can be difficult to secure such loans through other means.
What are Home Equity Loans Used For?
Technically, you can use a home equity loan to pay for anything. However, most people use them for larger expenses. Here are some of the most common uses for home equity loans.
- Remodeling a home. Payments to contractors and for materials add up quickly.
- Medical expenses. A major surgery or long rehab can result in high medical bills.
- Education. Loans can help pay for private secondary schooling or college.
There are, however, some cases where a home equity loan might not be the smartest financial solution. One example? Starting your own business. This is a risky proposition. If you use your home equity to start a business, and the business fails, you may find you’re unable to make the payments on your loan. Since you used your house as collateral, this could result in a worst-case scenario of losing your home, as well as your business.
You also may not want a home equity loan if you don’t plan to use a large amount of money at once. With a home equity loan, you receive a lump sum and must pay it back in installments each month. If you don’t need a large sum at once, you may be better off considering a HELOC or another loan that requires you to pay only for the portion of the loan you used.