How do Home Equity Loans Work?
Home equity loans are a mortgage that can be taken out against a home, depending on the amount of equity the property currently holds. But what is equity, and how can a homeowner determine how much equity they have in their home? Are there interest rates on home equity loans and, how are they determined? Just how do home equity loans work?
In their most simple form, a home equity loan is a loan that is given to a homeowner in a large lump sum amount at the beginning of the loan. The amount that’s given is determined by the amount of equity that’s currently in the home or rather, how much of the home the homeowner actually owns. That amount can be determined through a number of things such as increasing property values; updates, remodels, and other home improvements made on the home; and by the amount of the first mortgage the homeowner has already paid off. Every time a homeowner either increases the value of their home, or lowers the amount of debt they carry on it, they increase the amount of equity they hold in their home.
Because of this, a home equity loan can sit in either the first or second loan position against the home. If the homeowner has completely paid off their first mortgage or, in the rarest instances, has paid cash for their home outright, they will have 100% home equity and so, the loan will sit in the first mortgage position against the home. If however, there is already an existing first mortgage on the property, a home equity loan will be second in line to that first mortgage. This means that should the homeowner default on the first mortgage that will have to be paid off before the home equity loan is repaid.
Approving a loan that will only be repaid once the first mortgage has been paid off is riskier to the lender and so, the interest rates on home equity loans are typically higher than they would be for a first mortgage. They are also though, almost always offered at a fixed interest rate. When interest rates are low, this fact makes home equity loans a much better choice for homeowners over other types of second mortgages, such as HELOCs, which come with a variable interest rate and so, can have increased costs should national interest rates rise.
Because home equity loans are based on the equity of the home, it’s actual value will need to be determined and so, an appraisal will need to be done on the home. The cost of home appraisals can vary, but they are generally about $300 and are the responsibility of the homeowner to pay.
Home equity loans can work very simply, as things like income and credit score aren’t generally a factor in the approval process for them. Still, homeowners need to make sure that they fully understand how home equity loans work when compared to other types of home loans to make sure that a home equity loan is right for them.
Bryan J is the author of this article. For more information about Home equity loan or Second Mortgage please visit canadianmortgagesinc.ca.
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