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Understanding Home Equity

An equity loan is a mortgage loan in which an individual can borrow money by using real estate, generally their home, as collateral. Equity is the difference between the open market value of the house, minus what is owed on it. This means that if someone owns a home worth $200,000 but they owe $150,000 on the initial mortgage, then they have $50,000 in home equity. Most lenders would be willing to give around 80% loan to value, or $40,000 in this case.

The amount a person can borrow against their home depends greatly on a wide range of factors beyond how much equity they have available. Some other things which may be considered:

  • General Market Conditions: When markets contract during recessions banks may become quite selective with who they are willing to loan to. And when markets get frothy banks may fight to gain share loaning to more marginal borrowers.
  • Employment History: If you or your spouse have recently lost your jobs, are self-employed, or have unstable income then lenders may be more cautious.
  • Consumer Credit Score: If you have recently missed some debt payments your FICO score might drop. This in turn can cause you to either be charged higher rates of interest or to not qualify for lending. Repeatedly missing important payments like mortgage payments counts more than falling behind a month on a cable or cell phone bill.
  • Consumer Debt Profile: If you carry a variety of debts & have a high debt to income (DTI) ratio, that might limit how much a lender will consider prudent to loan.
    • The front-end ratio compares the cost of a home's mortgage and insurance against the homeowner's income. Lenders typically want this to be below 28%.
    • The back-end ratio compares the cost of servicing all consumer debt payments against a homeowner's income. Lenders typically want this to be below 36%.

Generally, the interest rate applied to equity loans is lower than the rate applied to unsecured loans, like credit card debt. The reason is that the home is used as collateral and the loan is considered to be safe. It is, after all, rather difficult to disappear with a house, or hide it for that matter. Also lenders find that borrowers make these payments a priority when their home is on the line.

Lending Department Comic.

A home equity loan is like a second mortgage. The borrower is given a lump sum and the amount is returned with interest over a mutually agreed upon time period. A home equity line of credit, on the other hand, works like a credit card. It allows the borrower to use from a credit line, up to the amount of the limit. If the loan is repaid, the credit becomes available again. The biggest advantage is that interest is paid only on the amount borrowed and not the whole credit line available. If it is repaid, then there are no payments to be made. The home equity line of credit can have a draw period of anywhere from five to thirty five years. The repayments can be as small as the interest only ending in a single balloon payment at the end of the draw period, or an extended repayment plan can be used.

Typical Fund Uses

Normally, home equity loans are used for the larger expenses, simply because homes have a very large value to borrow against. Very often, such loans are used to

  • remodel or renovate the existing house
  • pay for college education
  • finance a second home
  • consolidate other debts which carry a higher interest rates
  • or some combination of the above

Since borrowing such large amounts of money is serious business and one ends up putting their home on the line, it is important to estimate the monthly payment on the expected loan amount to make sure that the payments will be within one’s budget.

Leveraging Equity.

Equity Calculators

Trying to estimate how much one is eligible to borrow and if that payment is affordable can involve some rather complex calculations. Fortunately, there are many free online calculation tools that make the process simple. These calculators are user friendly and have clear instructions on how to go about using them.

A home equity loan calculator allows potential borrowers to try different loan combinations to see which option would be best suited to their needs and income. Using the calculator allows borrowers to see how much money they can borrow, what the repayment amounts will be, and even the tax deductions they will be able to avail. The calculator calculates the rate of payment on the loan by taking into account the amount of the loan, terms, and length of the loan.

Using the Calculator

Using the calculator is a simple procedure. Just enter the loan amount that is to be borrowed in the designated space. Next enter the interest rate that one hopes to pay. Remember to be realistic here, as the rate one wishes to pay may not be the rate they qualify for. Then choose the time period in which the loan will be paid back. Just keep in mind that the longer the loan period is extended, the more one ends up paying in interest. Finally, just click the calculate button and results will provide an estimated principal and interest payments that will be needed to repay the loan. One can juggle the loan amount and time period to come up with the monthly repayment amount that is affordable to them.

Potential borrowers should keep in mind that there might be additional costs involved in acquiring the loan. For example, there may be a fee for the property appraisal required to assess the real value of the house, an application fee, closing costs, property and title insurance, mortgage preparation, and filing costs. While a lot of these fees might be waived during the loan negotiations, some of the costs will not.

Since taking out a home equity line of credit line places one’s home on the line, it is essential that all costs and calculations are thoroughly researched using a home equity loan calculator before making a commitment.