How Home Equity Loans Work

Many people are beginning to ask how home equity loans work. With the condition of our economy, it often makes sense to check financing options for your family.
Home equity loans are fast becoming a very popular way to use the roof over your head as collateral to either consolidate debt or to purchase high ticket items.

So what is a home equity loan?

Let's start by defining 'home equity'. It is the difference between the current appraised value of your home and the outstanding balance of your existing mortgage(s). So, here is how home equity loans work. Equity home loans or a home equity mortgage refers to the percentage of the 'home equity' that a lender will allow you to borrow, using your home as collateral.

Why Are Home Equity Loans So Popular?

There are basically two reasons for their popularity:

  • 1. They carry low interest rates compared to credit cards and some other forms of credit.
  • 2. They are tax deductible.(in the US)

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Several years ago, changes in tax laws disallowed most consumer purchases as tax dedutions.
As a way to get around these tax changes, consumers began borrowing against their home value to make purchases. Equity home loans became a method to buy things or renovate and still get a deduction.

As an example, let's assume you bought your home for $100,000 and made a 25% down payment of $25,000. In order to repay the remaining $75,000, a lender gave you a first mortgage. On the day you closed escrow, you automatically had 25% equity and as you pay off the principal, your home equity grows in value.

Continuing with this example: As time has passed, you've paid $10,000 toward the principal of that first mortgage. During that same time, your $100,000 home has also increased in value to $120,000(Fair Market Value). So, your beginning equity ($25,000), plus the principal you have paid ($10,000) and the increase in your property value ($20,000) gives you $55,000 in home equity today. Use our home equity loan calculator to estimate how much you qualify to borrow against the equity in your home.

Equity is a Valuable Asset

Lenders and borrowers both benefit from home equity loans. Equity is a valuable asset and you can use it without having to sell your home. Since a home is the biggest asset most people have, lenders consider equity loans very secure. For that reason, interest rates for home equity mortgages are lower than for other types of loans.

How Home Equity Loans Work: The Downside

Earlier, we said that equity home loans are beneficial to both the lender and the borrower. However, like all credit and debt, a home equity mortgage also has a downside. The disadvantage to a home equity mortgage is that if you default on the loan, the lender could foreclose on your home. Also, as you take on a home equity mortgage, you are using up money that could be used later as a retirement fund. For this reason, home equity loans are statistically most suited to stable, middle aged borrowers.

More information on how home equity loans work

Now that you have an limited outline of how home equity loans work, look here for more information on how to get out of debt.

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Notable Quotes

quote openBuying a home is usually a wise financial decision because it allows you to invest your hard-earned income in a real asset that builds equity.quote close
~ Lamar S. Smith

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