Should I use a home equity loan?

small house

If you own your home and have been making your regular mortgage payments, you may have some equity.

Equity is the value of what you own in your home: the difference between what your home is worth and the balance of the mortgage you still owe. 

If your home is worth $250,000 and your mortgage balance is $150,000 you have equity in your home of $100,000 (250,000 – 150,000 = 100,000). 

What is a home equity loan?

Once you have meaningful equity in your home, one of the things you can do is borrow against it. This means taking out a loan from a lender, with your home as collateral for the loan.

The formula for how much you can borrow in a home equity loan usually approximates to 80% of your home’s value minus what you owe on the original mortgage.

Using the same numbers from our earlier example, you could borrow up to 80% of the $250,000 your home is worth, or  $200,000. Now subtract what you still owe on the mortgage ($150,000) to get $50,000. While that’s an estimate of what you’d be able to borrow in a home equity loan, the details vary by lender and other factors, like your credit score.

Why would I use a home equity loan?

Home equity loans often have lower interest rates than you could get from a personal loan, or a credit card. As a result, people often use these loans to make improvements or repairs to their home, for debt consolidation, or other large expenses.

The two basic types are a standard home equity loan and a home equity line of credit, also known as a HELOC.

With a standard home equity loan, you borrow a lump sum that you get up front. The details can vary, but it basically operates like a second mortgage. It usually has a fixed interest rate, and you pay it off over a certain time period. The payments are fixed and are due the same every month until it’s paid off. This type of loan is useful if you have a single, big expense you need the loan for like a big home repair.

The home equity line of credit or HELOC acts more like a credit card. You’re approved for a certain amount and you can borrow up to that amount when you need it. You can pay it off and borrow again, and again if you’d like. You can never borrow more than the limit, but as long as you’re paying it off you can go back to the line of credit until the term of the loan is up.

Most HELOCs require some minimum payments for an initial period, then require you to start making more substantial payments to pay off any outstanding balance later in the term. While standard home equity loans generally have fixed interest rates, a HELOC usually has a variable rate.

Like a credit card, the interest rates can change. HELOCs are better suited to circumstances when you don’t know exactly how much you’ll need, or when you’ll need it, or you think you may need smaller amounts several times.

What are the risks?

As with the original mortgage, the same risks apply. Since your home is the collateral, if you don’t pay the loan back according to the terms, your home could be repossessed. Another important point is that if you sell your home, the full amount of the loan is due at once. You don’t get to keep making monthly payments over time.

How much should I borrow?

A home equity loan is not a free source of money. You’ll pay fees for the application and underwriting, and interest on the balance as you pay it back. 

How much to borrow is up to you, not the lender. Just like any other type of debt, make sure you can make the monthly payments on the new loan, in addition to your existing mortgage, and all of your other monthly expenses.

If you’re considering taking a home equity loan for any reason, this is a great time to start a chat with a BrightDime coach. We can help you think through all your options, and to help you understand if this is a good alternative for your personal situation.