A home equity loan is a type of loan in which the borrower uses the value of their home as collateral. If the borrower defaults on the loan, the lender can foreclose on their home. Home equity loans are typically used for significant expenses such as home repairs, medical bills, or college tuition.
The loan amount is typically based on the equity in the home, which is the difference between the appraised value of the property and any outstanding mortgage balance. Home equity loans can be used for various purposes, including debt consolidation, home improvements, or other significant expenses.
The interest rate on a home equity loan is usually lower than that of a traditional mortgage or personal loan because your house serves as collateral for the loan. In addition, interest paid on a home equity loan may be tax-deductible (consult your tax advisor to confirm).
Types of Home Equity Loan
- Home Equity Lumpsum Loan: A home equity lumpsum loan, also known as an equity loan or second mortgage, is a consumer loan secured by a second mortgage, allowing homeowners to borrow a lump sum against the equity in their home. The loan is based on the difference between the homeowner’s equity and the home’s current fair market value. Interest on such a loan is payable on the entire amount sanctioned and transferred. It keeps on reducing as per the loan repayment.
- 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, i.e., their home. Once a maximum credit facility is established, the homeowner may draw on the line of credit at their 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.
Example of Home Equity Loan
Most lenders require you to have a certain amount of equity in your home before you’re eligible for a loan. For example, let’s say your home’s current market value is Rs 50 lakhs, and you have Rs 20 lakhs remaining on your mortgage. Then, using the calculation above, subtract Rs 20 lakhs from Rs 50 lakhs to find your home’s equity, i.e., 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 would be 40 percent (i.e., 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. However, if you have a low LTV ratio, you have more home equity and may be eligible for more loan amounts.
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, i.e., 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 it would look 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.
Features of a Home Equity Loan
- A home equity loan is offered as a single lumpsum amount.
- Such loans usually have fixed rates and equal monthly payments over 15 to 20 years. Generally, the repayment period is shorter than that of the primary mortgage.
- The interest rates are higher than those of primary mortgages and lower than those offered by credit cards and auto loans.
The interest paid on a home equity loan may be tax-deductible, provided the loan is taken for renovation, significant repairs, or additional house construction. That is, it lowers the taxable income and thus, gives the chance to save by paying less tax.
Advantages of a Home Equity Loan
- A home equity loan helps the recipient renovate and buy a second home.
- The loan amount could be used for educational expenses, medical treatment, etc.
- A second mortgage can assist in paying off unsecured debts like credit card dues, car loans, etc. It also helps to consolidate and pay off loans taken at high-interest rates.
Disadvantages of a Home Equity Loan
- Home equity loans are often taken to pay off credit card or personal loan debts. But this may tempt an individual to take further cash from the credit card balances or a personal loan, thereby increasing his unsecured debt and reducing his home equity to a large extent.
- Risk of losing your home if payments aren’t made.
- There may be problems with selling your home with an outstanding loan.
- Certain home restrictions may apply with a home equity loan.
Conclusion
Home equity loans could be helpful and used for various purposes, such as debt consolidation, home improvements, or other significant expenses. If you’re considering taking out a home equity loan, there are several things to remember. Most importantly, your home is at risk if you default on your loan payments—you could lose your house if you can’t repay what you borrowed.
