A home equity loan is one where the borrower is required to use the equity in their home or property as collateral in order to get the loan. The amount you get would be based on the value of the property.
Home equity loans are considered to be a second mortgage that borrowers can take out by using their home’s equity as collateral. These loans are a convenient option for individuals looking to obtain funding for different activities, such as launching a business, remodeling the property, or financing an investment operation.
Most lenders offer home equity loans due to their low-risk nature, and, because of the collateral, interest rates are often lower than personal loans. Continue reading for an explanation on home equity loans, how they work, and their main benefits and disadvantages.
Most homeowners finance the purchase of their properties by using a mortgage. Mortgages are issued by financial institutions, and their amount varies depending on the value of the property. In most cases, the transaction is funded through the loan as well as a down payment (commonly from the borrower’s own savings), and the home’s equity will typically be equal to the amount of the down payment.
Subsequently, as the borrower pays for each installment of the mortgage, the balance is reduced, and the portion of the property that is owned by the borrower increases. This portion is known as the equity portion. This portion of the property that the borrower owns can be used for a home equity loan, which is considered to be a second mortgage on the property.
The financial institution has a claim on the property’s value, so if the borrower defaults on their payments, the property can be foreclosed to cover for the loan’s outstanding balance.
The volume of home equity loans in the United States reached a peak during the 2008 subprime crisis, but since then, their volume has progressively declined. By the end of 2019, the value of home equity loans in the United States was approximately $318 billion, a 46% decline compared to their value in 2008, which was nearly $590 billion.
Just like with other financing instruments, obtaining a home equity loan has various advantages and disadvantages:
The specific requirements to apply for a home equity loan varies between lenders, but most lenders impose some of the following conditions:
Home equity loans are issued as a lump sum payment, and they can be used for various purposes. These loans are repaid through a set of installments that usually extend from 10 to 25 years.
Each installment contains a portion of the loan’s outstanding balance and an interest charge paid to the lender as compensation for facilitating the funds. As each installment is paid, the homeowner progressively recoups a portion of the home’s equity.
Prior to 2017, the interest charges paid on home equity loans were fully deductible from a person’s taxes. This increased the popularity of these loans since they were a cheap alternative to other types of consumer loans.
Nevertheless, the Tax Cuts and Job Acts of 2017 eliminated the possibility of deducting the interest paid on these loans except for situations where the loans are used to buy, build, or improve the taxpayer’s home.
This modification lowered the appeal of home equity loans, even though they are still an attractive option due to the lower interest rate charged on home equity loans compared to personal loans.
Since a home equity loan works as a mortgage, the underlying property serves as collateral if the borrower fails to fulfill their financial obligations. This means that lenders have the right to foreclose on the home, even though they can decide not to under certain circumstances.
For example, if the value of the loan is significantly lower than the value of the property, the lender will probably choose to foreclose on the home. There’s a high chance that they will obtain enough money from selling the property to cover for the outstanding balance of the debt.
On the other hand, if the value of the home has declined and is now lower than the outstanding balance of the debt, the lender may decide not to foreclose the home as it will probably result in a financial loss. Nevertheless, the lender could still file a legal claim against the borrower, which could ultimately affect their credit situation.
A borrower’s payment history on a home equity loan can affect their credit score. These loans are treated as a regular credit account, and any late payments will negatively impact a person’s credit situation.
Home equity lines of credit (HELOCs) are also considered a second mortgage, but they work differently than home equity loans as they are revolving credit accounts. This means that instead of a lump sum payment, HELOCs allow the borrower to withdraw money from the credit account and repay the balance at any given point during the draw period.
Some of the most important differences between a home equity line of credit (HELOC) and a home equity loan:
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