How does a mortgage loan work?
How does a mortgage loan work?

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If you own a house, that’s probably the biggest asset to your name. This value can be leveraged for you in the form of collateral for a loan, which you can use for anything you want, from home renovations to paying for emergencies.

That’s the essence of what a home equity loan is: the money you borrow against the value of your home.

Here’s what you need to know about home equity loans and how they work.

What is a home equity loan?

“A home equity loan is a loan where a homeowner can borrow money from a bank and the equity in their home serves as collateral for the loan,” explains how Elliott PepperCPA, CFP and co-founder of Northbrook Financial, defines the term.

How does a mortgage loan work?

There are two basic forms of borrowing against the value of your home: a home equity loan or a home equity line of credit, also known as a HELOC. The two should not be confused. With a home equity loan, you get a lump sum paid to you; With a HELOC, you have a line of credit, up to a predefined maximum amount, that you can draw on for large expenses or to consolidate debt.

If you’re considering getting a home equity loan, keep in mind that since your home serves as collateral, the lender could repossess it if you don’t repay the debt.

How do you calculate the equity in your home?

Home equity is simply the difference between the value of your home – the amount it could sell for today – and what you owe on the mortgage. If you have a $100,000 mortgage on a property valued at $300,000, the equity in your home is $200,000. If you own your home free and vacate, without a mortgage, its total value is the equity in your home.

How to Use Home Equity Loans

You can use a home equity loan for just about anything – it doesn’t have to be tied to the house. However, the loan will be tax deductible if you use the funds to substantially improve your home, as well as if the total debt related to the home does not exceed $750,000. This includes all other mortgages and/or home equity loans.

Types of home equity loans

There are three main types of home equity loans. Let’s take a closer look.

Fixed Rate Home Equity Loans

A fixed rate home loan is a lump sum paid to you, with a fixed interest rate over time. That makes it an attractive option for big, one-time expenses, like buying a new roof or financing a large-scale home renovation.

The more equity you have in your home, the more you can borrow, usually up to 85% of that equity. Home equity is the current value of your home minus what you still owe on your mortgage.

Home Equity Line of Credit (HELOC)

A HELOC is a variable interest rate line of credit. You receive credit up to a predefined maximum amount, similar to how a credit card works.

You can tap into this credit for expenses such as home renovations or to consolidate higher-interest debt. Because the line of credit remains available for a long period – a typical term is 25 years – it is a good way to finance ongoing real estate projects; it can also be a source of funding for future needs as they arise.

Refinancing by withdrawal

With a cash refinance, you pay off your existing home loan and get a new one that’s bigger than you owe. You will then receive a check for the price difference.

How to qualify for a home equity loan

To qualify for a home equity loan, you must ensure that you meet the following conditions:

  • A credit score above 680
  • At least 15% equity in your home
  • A loan-to-value ratio of 80% or less
  • Sufficient income
  • Reliable payment history

Your credit score will also play an important role in determining not only if you can get a loan, but also what your interest rate will be.

“A common baseline for qualifying for a home equity loan is 680, but the higher the credit score, the lower the interest rate will be,” Pepper says. (Here’s how to check your credit score for free.)

Home equity loans have a much lower annual percentage rate (APR) than unsecured loans like credit cards because they provide security to the lender in the form of collateral.

In May 2021, the average interest rate on a home loan was around 5.26%, according to data compiled by Bankrate (which shares an owner with NextAdvisor). With good credit, you can get a home equity loan with an APR of less than 4%, Pepper says. Because interest rates are low right now, if you have good credit and the rate on a loan you’re inquiring about is no lower than 4%, “there’s probably something wrong Ford says.

Most home equity loans have terms of five to 30 years.

The more equity you have in your home, the more you are eligible to borrow; generally, you can borrow up to 85% of the equity in your home, depending on the quality of your credit and the amount of your other debts, the The Federal Trade Commission says.

A key statistic in this regard is the loan-to-value ratio. Lenders will consider more favorably – and grant lower interest rates – borrowers with a lower ratio, all other things being equal. Often, the maximum acceptable is 80%, which means that the mortgage balance should not exceed 80% of the current value of the house.

Paying off a home equity loan is a bit like paying off your mortgage: you’ll have a fixed annual percentage rate and make monthly payments over the life of the loan.

Borrowers can deduct the interest they pay on a home loan from their taxes, just as they would on a mortgage, but there are some limitations.

For loans started after December 15, 2017, “taxpayers can only deduct interest on up to $750,000 of eligible loans, which includes the value of your current mortgage and home equity loan.” , explains Pepper. “In addition, the proceeds from the home equity loan must be used to build or significantly improve your home.”

He also notes that this is an itemized deduction, which means that depending on your situation, you may be better off claiming the standard deduction and therefore not deducting any interest on the loan. immovable.

Where to apply for a home equity loan

If you are considering getting a home equity loan, the first thing to do is shop around and compare offers from various lenders.

Pro tip

There may be a lot of value stored in your home, but shop around before tapping into it with a home equity loan.

“Most major banks and financial institutions offer home equity loans, so it’s always a good idea to get a few quotes and compare the terms, especially the interest rate and other fees, to make sure you get it.” ‘get the loan that’s right for you,’ says Pepper. .

A good starting point is the bank you are already a customer of. You may even need to have an account with the bank in order to get a home equity loan from them. Working with your existing bank could also get you a lower interest rate, says Russ Ford, financial planner and founder of Wayfinder Financial.

Who should consider a home equity loan?

Taking out a home equity loan is something you might consider “if you need to pay something but don’t have the money to do it,” says Michael Caligiuri, CFP, Founder and CEO of Caligiuri Financial.

One of the most common reasons for getting a home equity loan is for home renovations and improvements. “Using a relatively low-interest loan, especially if it’s to cover the cost of a major home improvement or renovation, could be a smart financial decision,” says Pepper. Indeed, improvements or renovations can end up increasing the value of your home in the long run, as well as a better quality of life.

Home improvement projects — like painting, installing new floors, or even trading in your appliances for new ones — aren’t the only possible use for these loans, though.

Home equity loans can also be used to pay college fees or pay off higher-interest debt, says Lindsay Martinez, CFP, owner of financial planning firm Xennial Planning in San Juan, Puerto Rico. But be careful: you would be borrowing against your house to pay an unsecured debt, that is to say, not guaranteed by a guarantee. “You shouldn’t take out a home loan for personal expenses like a boat or a luxury vacation,” she advises.

But taking out a home equity loan can be a way to access a huge source of value and put it to good use, especially at a time – during the recession caused by the coronavirus pandemic – when people are facing economic difficulties.

“Many people are very stressed from a liquidity perspective, and their only real option may be to get a fixed rate home loan,” says Michael Caligiuri, CFP, Founder and CEO of Caligiuri Financial.

Conclusion

Getting a home loan is not a decision to be taken lightly, but it can be a financial lifesaver in certain situations. Most borrowers use the money for home improvement projects that can increase long-term value, but there are several other ways to use a home equity loan. Just be sure to do plenty of research before you commit, as you’ll also be agreeing to pledge your home as collateral.

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