How Does a Home Equity Loan Work?

How Does a Home Equity Loan Work?
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Whether life has blindsided you with an unforeseen financial emergency or you simply want to make a luxury purchase that’s not supported by your current budget, the equity in your home may come to your rescue. If you subtract what you owe on your mortgage loan from the appraised value of your home, the difference is your home equity. As long as this amount is a positive number, it's likely you will qualify for a home equity loan.

How Does a Home Equity Loan Work?

A home equity loan allows you to borrow money using your home’s equity as the collateral to secure the loan. Lenders for home equity loans include mortgage companies, savings and loan companies, banks and credit unions. Each lender typically has different guidelines that you must meet to qualify for a home equity loan, and each may also offer different loan terms such as interest rates, fees and lengths of the loan. After you’ve closed on your home equity loan, you’ll have a monthly loan payment that you make in addition to your home mortgage loan payment. You can use the money as you wish, including consolidating debt, making home improvements, covering educational expenses or even buying a new car.

What Is the Difference Between a Home Equity Loan and a Second Mortgage?

There’s no difference between a home equity loan and a second mortgage; a home equity loan is considered one type of a second mortgage. Your original mortgage loan – the one you used to buy your house – is the first, or primary, mortgage. As long as you’re still paying on your first mortgage loan, all other loans that use your home equity as collateral are considered second mortgages. It’s called a “second” mortgage because it is subordinate to your first mortgage. This means that if you sell your home, the primary mortgage loan balance must be paid first. The second mortgage loan balance is paid next.

How Does Interest on a Home Equity Loan Work?

The specific interest rate for a home equity loan varies among lenders, and it can be fixed, (it stays the same over the life of the loan) or it can be variable (it changes over the life of the loan). Some fixed-rate loans are “convertible;” that is, they begin at a fixed rate but they may convert to an adjustable rate during the life of the loan. Adjustable-rate loans have periodic caps, which establish maximum interest rates during certain periods of time, as well as a lifetime cap, which is the maximum interest rate you’ll pay during the life of the loan. The Federal Trade Commission (FTC) notes that the annual percentage rate (APR) is the most important factor to consider when you’re comparing loan plans. The APR includes the interest rate, but it also includes fees and other charges you’ll pay to the lender.

How Much Can You Borrow on a Home Equity Loan?

Typically, lenders put a cap on the maximum amount you can borrow at 85 percent of a home’s equity. This amount can vary, depending on your credit history, your income and your other debts. Most lenders require an appraisal of your home to determine its fair market value so they know how much you can borrow for a home equity loan. Fannie Mae® guidelines note that a property must have a current appraisal that is no older than 12 months from the date of your mortgage.

Can You Sell Your House If You Have a Home Equity Loan?

You can sell your house if you have a home equity loan if your net profit from the sale is sufficient to satisfy your first mortgage as well as your home equity loan. If your profit covers your first mortgage but comes up short to pay your home equity loan, you may still sell your home if you have additional, personal funds to kick in that will pay off your home equity loan. Another option is asking your lender if he will agree to a “short sale,” which is the sale of your home for less than what you owe on it.

Home Equity Loan Considerations

Even a trusted lender can't help you comparison-shop for a home equity loan; ultimately, that's your responsibility. The Office of the Comptroller of the Currency, U.S. Department of the Treasury, has a downloadable worksheet to help consumers as they shop for a home equity loan. You can download this form by visiting and typing “home equity loan worksheet” in the internal search block at the top of the page. When the search results load, click on “Comparison Shopping for a Home Equity Loan Worksheet.” This worksheet addresses all facets of home equity loans and provides you with an at-a-glance cost consideration to help you make the best decision for your loan.