Often referred to as a “second mortgage”, a home equity loan is a type of loan where the borrower disposes to the lender its equity to the home as collateral.
To better understand home equity loans, let’s do a chronological rundown of the life of homeowner Donna:
When Donna decided to buy Steve’s house, she borrowed money from a bank. Their mortgage deal was: the bank gave Steve the whole amount he was asking for the house and became the owner of it. In order to live there, Donna will pay monthly installments to the bank. Should she default a lot, aside from her credit score being punished, the lender could open up a foreclosure auction to recover some of the money it put in the transaction.
But Donna never did. She paid everything correctly. Every installment paid actually meant she acquired equity to the house, right? The bank starts with 100% and Donna 0%.
In comes the home equity loan: because she is acquiring equity to the home, she can use it as collateral to the same bank or another lender. She can take the 40% of the house she already owns and say: “hey, let me borrow some money. Have my share if something happens.”
So, basically, it’s like the homeowner is getting the worth of his/her asset (the house) and turning into live money. What good is a house “worth” $1 million if you cannot use that money? Well, with home equity loan you can, as it turns the house magically into paper money for a while.
Is the home equity loan a little bit clearer, now?
Things to know:
To assert the amount of a home equity loan, the lender (usually a bank) sends an appraiser to determine the house’s market value. If your neighborhood’s prices went up, the amount of your loan can grow as well, making 20% of equity feel like 40%. But the opposite can happen too…
Home equity loans can be used to refinance a house, but not to buy a new house. And after the 2018 tax reform, the interest on the loan is no longer deductible on income taxes.
It has low-interest rates because the loan is secured by a house, it usually bears variable rates, and it requires basically the same heavy paperwork a regular mortgage does. Be prepared to pay for Closing costs even though you are not buying a new house; you still have to go through a lot of fees and paperwork. Home equity loans closing costs total 2 to 5 percent of the amount borrowed.
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