How Does a Home Equity Loan Work?

How Does a Home Equity Loan Work?
How Does a Home Equity Loan Work?

How Does a Home Equity Loan Work

A home equity loan is basically a second mortgage on the home you are already purchasing. If you already own the home free and clear it will be your only mortgage but will still be considered a home equity loan. Equity means the portion of the home that you own that is not mortgaged. For example: If you purchase a home for $200,000.00 and have $50,000.00 as a down payment, you will need to borrow $150,000.00 from the bank or lending institution.

You have $50,000.00 worth of equity in the home because this is the portion you purchased outright. As the mortgage loan is paid down, your portion of equity increases because you have paid more of the original $150,000.00 loan off. If property values increase in your area and your home is worth more than the original asking price of $200,000.00, your equity value increases.

If the property value in your neighborhood declines, you can also lose your equity value as the home is now worth less than your original purchase price. It stands to reason that homeowners should keep their homes in good repair and know what the market value is in their area.

There are two types of home equity loans that a home owner can apply for. One is a standard loan. This loan works just like your mortgage payment. You will borrow X amount of dollars, up to what ever your equity is in the home or whatever your lender will allow. You will pay this back over a certain period of years. You will also pay whatever the current interest rate is at the time of the loan.

Most lenders will only accept very short year terms on a home equity loan, so you may be faced with a large first mortgage payment and a large home equity loan. You can't borrow more against any equity until this loan is paid off. Some banks may allow you to redo the entire equity loan and add to it, providing you have paid down enough, and the loan doesn't exceed the equity you own in the home.

The second type of home equity loan is a revolving line of credit. This one works just like a credit card. A predetermined amount of credit is determined by your bank, and you have access to that amount of money as you need it. As you make your monthly payments the line of credit increases again, and you can continue to use X amount of dollars and pay it back. You are also charged a monthly interest rate, just like a credit card.

Both of these type of home equity loans are secured by your home, just like your first mortgage. If you default on home equity loans, you could be in danger of losing your home, just like on your first mortgage agreement. Home equity loans are great when you need to do major repairs or remodeling. They can also help with unexpected emergency expenses.

They can also build up a lot of debt that you may not be able to afford to pay back. Think wisely before choosing either one, and risking your home to foreclosure.