When you use your home as collateral for a loan, you take out a second mortgage equal to all or a percentage of the equity you have in the home. Equity is the difference between a home's appraised value and the outstanding mortgage balance.
This adds two additional criteria to the lender's income and credit qualification requirements. The first criterion is that you are the home's legal owner. The second is that either you own the home outright or the home is worth more than the outstanding balance on your mortgage loan.
How It Works
Equity Calculations
Equity is a fluid variable. Although it usually increases as you continue making monthly loan payments, a dip in the economy can cause both the value of your home and the equity you have in it to decrease. This is why most lenders require either an automated or an actual appraisal before making an equity calculation.
An equity calculation subtracts the outstanding loan balance from the home's current value. For example, if you owe $175,000 on a home currently valued at $250,000, you have $75,000 in equity. This amount becomes the basis for determining how much you are eligible to borrow.
How Much Can You Borrow and For How Long?
Most lenders will only lend you a percentage of the equity in your home. According to the Federal Trade Commission, the average is about 85 percent. For example, if you have $75,000 in equity, the maximum loan or line of credit would be $63,750.
A home equity loan is a one-time lump sum loan for which you make regular monthly payments over a set amount of time. A home equity line of credit works much the same as a credit card. However, unlike with a credit card, a HELOC usually has a predetermined draw period, followed by a set repayment period. During the draw period, you can borrow up to the limit set by the lender. As you pay off the principal, you can continue using the credit line, just like a credit card. However, once the draw period expires, you must pay off the loan.
Although loan terms vary between lenders, the repayment period is usually shorter than for the original mortgage. According to Bankrate, the maximum repayment period for both a loan and line of credit is about 15 years.