How Does a Home Equity Loan Work?

How Does a Home Equity Loan Work?
  • A Home Equity Loan (HEL) allows you to borrow money without refinancing your current mortgage.
  • Some reasons to take a HEL include debt consolidation, paying for home improvements and college expenses.
  • Check how much equity you have and what is your best home equity loan alternative.

What is a Home Equity Loan?

A home equity loan is a special type of mortgage, which allows you to tap into your home’s value to take out cash. There are many reasons to take out a home equity loan including debt consolidation, home improvements, or paying for college.

Home prices are up, and you probably have built up equity in your home. If you are looking for cash with a long-term payment schedule, low-interest rates, and low monthly payments, then a home equity loan is a great alternative. In most cases, a home equity loan is a second mortgage, which means that you take you don't pay off your current mortgage.

Home Equity Loan: How Does it Work

Home Equity Loan requirements are similar to other mortgages. Here are three essential steps to taking a home equity loan:

  1. Figure out how much equity you have, and how much you can take out, based on lenders Loan to Value (LTV) guidelines.
  2. Once you figure out how much you want and whether that amount fits into your needs, you can estimate the monthly payment for the HEL, in addition to your current mortgage.
  3. Finally, to qualify for a Home Equity Loan, lenders look at your loan to value ratio, credit score, and debt-to-income ratio.

How Much Home Equity Do You Have:

When you financed your home purchase, you made a down payment and then took a mortgage to buy the home. Your down payment represents the amount of equity you have. However, some events occurred since you purchased your home. Firstly, you paid off part of your mortgage. Secondly, home prices changed, sometimes up and other times down. To calculate your current home equity, you need to know your existing home’s value and the balance of your mortgage(s).

Here is a simple example. If your home is worth $400,000 and your current mortgage balance is $320,000, then you have $80,000 in equity. Can you take out a Home Equity Loan for $80,000? The answer is most likely, No, but in some circumstances, possibly yes.

Formula for Home Equity

Home Equity - How Much Can You Take Out

How large of a home equity loan can you take? That would depend on your Loan to Value ratio, and lenders’ rules and guidelines. Your LTV is easy to calculate. Using the previous example, your LTV is 80%: $320,000 / $400,000.

In general, lenders allow for a combined LTV (CLTV) of about 80%. It is essential that you align your cash needs with the amount of money that lenders will offer.

Home Equity: LTV

Choose the Right Type of Home Equity Mortgage

Are you trying to decide which type of mortgage to take? Use Choosing a Home Equity Loan Mortgage Calculator to decide between a cash out refinance, home equity loan, or HELOC.

The Bayer Family Needs Cash - An Example of How Home Equity Loan Works

The Bayer family bought their home several years ago for $250,000. They estimate that the current value is about $300,000. They took out a 30-year mortgage at 3.25% and now owe about $170,000. They need about $40,000 to consolidate medical bills and credit card debt and pay for their daughter’s college tuition. Do they have enough equity in their home to qualify for a Home Equity Loan? Let’s run the numbers:

The Bayers have $130,000 of equity in their home ($300,000 - $170,000). Their current LTV is 58%. If they extended their CLTV to 80%, then they could borrow up to $240,000 against their home, or an additional $70,000. If they borrow another $40,000, their CLTV will be 71%. Their monthly payment today (principal and interest) is about $979. Assuming that they borrow the $40,000 for 15-years, the additional payment would be $296. The Bayers could also borrow the $40,000 for 30-years and reduce the monthly payment to about $191.

Home Equity Loan Calculator - With Monthly Payments Home Equity Loan Calculator 

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