Home Equity Loan: How it Works and Requirements
What Is a Home Equity Loan?
A home equity loan is a type of consumer debt also known as a home equity loan, home equity installment loan, or second mortgage. Home equity loans allow homeowners to borrow the value of their homes. The amount of the loan is determined by the difference between the current market value of the home and the balance of the homeowner’s mortgage. Home equity loans are usually fixed rates, while home equity lines of credit (HELOCs) are usually variable rates.
How a Home Equity Loan Works
A home equity loan is similar to a mortgage, hence the term second mortgage. The lender uses the equity in the home as collateral. The amount a homeowner can borrow is determined in part by a combined loan-to-value ratio (CLTV) of 80-90% of the appraised value of the home. Of course, the loan amount and interest rate are also determined by the borrower’s credit rating and payment history.
Traditional mortgage loans, like traditional mortgages, have a fixed repayment term. The borrower makes regular, fixed payments that cover both principal and interest. If the loan is not repaid, the home can be sold to pay off the remaining debt, as with any mortgage.
A home equity loan can be a good way to turn the value of your home into cash, especially if you use the money to make improvements that will increase the value of your home. However, be aware that you are putting your home at risk: if real estate values go down, you may end up owing more than your home is worth.
If you decide to move, you may lose money on the sale of your home or be unable to move at all. And if you take out a loan to pay off credit card debt, resist the urge to rack up new charges. Consider all your options before taking any action that could jeopardize your home.
Home Equity Loan Requirements
Each lender has different requirements, but most borrowers need the following to obtain a home equity loan:
- Equity in their home greater than 20% of their home’s value
- Verifiable income history for two or more years
- A credit score greater than 600
Although it is possible to obtain a home equity loan without meeting these conditions, you should expect to pay a much higher interest rate if you use a lender that specializes in subprime borrowers.
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