What is a Home Equity Loan?
A home equity loan — also known as a second mortgage, term loan or equity loan — is when a mortgage lender lets a homeowner borrow money against the equity in his or her home. If you haven’t already paid off your first mortgage, a home equity loan or second mortgage is paid every month on top of the mortgage you already pay, hence the name “second mortgage.”
A home equity loan or second mortgage can be a source of money to fund your major financial goals, such as paying for college education or medical bills, and can prevent building up credit card debt with high interest rates. Just beware: with a second mortgage, you are putting up your home as collateral for the loan, so if you default on this second mortgage, the bank can take your home. And this type of loan will reduce the equity you have in your home. So when you sell your home, you’ll have to pay off both your first and second mortgages with your sale proceeds.
Make sure you’re able to pay a second mortgage on top of the mortgage you’re already paying. Plan carefully and talk to your financial adviser to see if a second mortgage makes financial sense for you.
Home equity loans or second mortgages are different than a home equity line of credit (also called a HELOC). With a home equity line of credit, you receive a line of credit secured by your house, and you can use it as you need it, similar to a credit card. With a home equity line of credit, you won’t receive a lump-sum payment like you would with a home equity loan.
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How Do Home Equity Loans Work?
The amount of money you can borrow with a home equity loan or second mortgage is partially based on how much equity you have in your home. Equity is the difference between the value of your home and how much you owe on the mortgage.
An example may help illustrate: Let’s say you own a house now valued at $300,000. You put down $30,000 when you bought it and have paid down $30,000 in mortgage principal. You would have $60,000 in equity ($300,000 value of home – $240,000 still owed = $60,000 in equity) in the home.
The lender would use this equity number — in addition to your credit score and income — to determine how much of a loan you will get. Your lender will need to pull your credit report and verify your income to determine the interest rate you’ll pay for your second mortgage.
Typically homeowners borrow up to roughly 85 percent of the equity in their home. The longer you pay down the mortgage and the more your home appreciates in value, the more equity you build up in the home and the larger a home equity loan you may qualify for.
If you get a home equity loan, you will receive the entire amount of the loan all at once, as opposed to a home equity line of credit, which works similar to a credit card, where you take just what you need when you need it, and then pay it off in monthly installments. Often, you have to pay off a home equity loan or second mortgage within about 15 years, though the terms vary. The interest rate on the loan is typically fixed.
Similar to your first mortgage, second mortgages will require closing costs, which can cost about 3 -6 % of the amount of the loan. So be sure to shop around for different offers from lenders, as the cost of a second mortgage can vary from lender to lender.
What Can a Home Equity Loan Be Used For?
As a homeowner, you can use home equity loans or second mortgages for almost anything you want. Since the money comes as a lump sum (unlike a home equity line of credit), many homeowners use them for large, one-time expenses, such as:
- Home repairs, upgrades, or large remodel projects
- Paying for kids’ college tuition
- Paying off high-interest credit card debt
Often, the interest rates on home equity loans or second mortgages are much lower than rates on credit cards, so this can make financial sense as an alternative to using a credit card if you’re careful.
What Fees Do I Need to Pay?
Home equity loans or second mortgages have fees similar to what you paid for your original mortgage, which may include:
- Appraisal fees
- Originator fees
- Title fees
- Closing fees
- Early pay-off fee
Different lenders will charge different amounts for fees, and each lender may offer you a different interest rate. So be sure to shop around and talk to at least 2-3 lenders about a second mortgage or home equity loan, and compare the overall cost for each loan to find the one that makes the most financial sense for you.
Who Should Consider a Home Equity Loan?
If you need a lump sum of money for something important (such as a home repair, not a vacation or something fleeting) and are sure you can easily repay a home equity loan or second mortgage, it’s worth considering. The rates on a home equity loan tend to be significantly lower than rates on credit cards, so a second mortgage can be a more economical option than paying for what you need with plastic. And sometimes the interest paid on home equity loans or second mortgages is tax deductible, so this may be an added financial bonus (talk to your tax advisers, as this varies person to person).
Just remember, you will get all this money in one lump sum, and you can lose your home if you don’t repay the loan. So make sure that a second mortgage makes financial sense for you, rather than an option such as a home equity line of credit, where you can take out the money little by little.