Taking out a mortgage when buying a home represents the largest single debt most people will ever incur. But buying a home can sometimes involve even more debt than just the mortgage. Some home buyers opt to take out additional loans or lines of credit on their homes.
- Home Equity Loans. A home equity loan, also known as an equity loan or second mortgage, is a consumer loan secured by a second mortgage, allowing home owners to borrow against their equity in their home. The loan is based on the difference between the homeowner’s equity and the home’s current fair market value.
- Home Equity Lines of Credit. A home equity line of credit (HELOC) is a line of credit extended to a homeowner in exchange for collateral—their home. Once a maximum credit facility is established, the homeowner may draw on the line of credit at his or her discretion. Interest is charged at a predetermined variable rate, usually based on the prevailing prime rate. Once there is a draw on the HELOC, the homeowner can choose any repayment schedule, as long as minimum interest payments are made monthly. The term of a HELOC can last anywhere from one to twenty years, at the end of which all balances must be paid in full.
How Do You Build Home Equity?
Your home equity can increase in a few circumstances:
- When you make mortgage payments.
- When the property value rises.
- When you make certain improvements to the property.
Home Equity Loan Example:
Most lenders require you to have a certain amount of equity in your home before you’re eligible for a loan. Let’s say your home’s current market value is Rs 50 lakhs and you have Rs 20 lakhs remaining on your mortgage. Using the calculation above, subtract Rs 20 lakhs from Rs 50 lakhs to find your home’s equity: Rs 30 lakhs. This means you have 60 percent equity in your home (Rs 30 lakhs divided by Rs 50 lakhs is 0.60, or 60 percent) and a loan-to-value ratio of 40 percent (the percentage of your home that you’re still paying off)
Lenders typically cap borrowers’ loan-to-value ratio at 70 or 75 percent, meaning you won’t qualify for a loan if your LTV ratio is higher than that. If you have a low LTV ratio, meaning you have more equity in your home, you may qualify for better rates.
Once you qualify, your lender will also determine what percentage of your equity you can borrow. This is also typically around 80 percent. In this scenario, you would multiply your home’s value (Rs 50 lakhs) by 0.80 (the maximum percent the lender allows you to borrow) and subtract your remaining mortgage (Rs 20 lakhs). Here’s what that looks like:
Rs 50 lakhs x 0.80 – Rs 20 lakhs = Rs 20 lakhs
That Rs 20 lakhs is how much you’ll be able to take out in a home equity loan.