Home equity loans - understanding the terminology
What is a home equity loan
"Home equity loan" is one of those phrases that have come to mean all things to all men. There are several different financial instruments going by that name, and our first job is to disentangle them. Once we've done that, we can go on to thinking about the advantages and disadvantages of these loans.
In brief, "home equity loan" can simply mean a second mortgage - a fairly familiar term. Or, it can refer to a "HELOC", a "home equity line of credit", something else entirely
Second mortgages
A second mortgage isn't all that different from a first mortgage. It offers you a lump sum secured on your home, with repayments structured in much the same way as any other mortgage. This kind of home equity loan is suitable if you need a lump sum for some purpose - buying a car would be a typical example.
Because a home equity loan is secured on your home, you can often get a better deal on it than would be possible with an unsecured loan. The downside, of course, is that you could lose your home if you fail to make your payments - but this need not be a catastrophic risk as long as you aren't borrowing more than you can afford.
Home Equity Lines of Credit
Suppose you want to borrow against the equity that is tied up in your house, but you don't need a lump sum. This might be the case if you have an ongoing series of outgoings, such as medical bills or improvements to your home. Taking out a lump sum loan in this situation would be sub-optimal, because much of the loan would have to sit in your bank until it could be used. Instead, you would like to have the equivalent of an overdraft - the option to borrow smaller amounts of money as and when you need them. That is what a Home Equity Line of Credit, or HELOC, offers you. It is analogous to arranging an overdraft against your house.
How much can I borrow?
The amount of money available to you in a home equity loan will depend on four things: the value of your home, the amount of any existing mortgage, your credit rating, and the lender. Let's take them in order.
First, the value of your home. Typically, you will find it very difficult to borrow more than 100% of the value of your home in loans secured against it. Admittedly it is possible to borrow a little more in some cases - some home equity lenders will allow up to 125% - but this is often only available to the most credit-worthy. Also, lenders expose themselves to risk in lending more than the value of your property, so they will compensate by jacking up their rates and charges. Note that the value of your home will depend on how it is appraised by the lender. The appraisal value could differ significantly from how much you think your house is worth, and this could affect your ability to secure a home equity loan. But different lenders may use different appraisal techniques, and so it is possible that one will put a higher value on your home, making it easier for you to borrow.
The next thing to consider is the amount of the mortgage that you already have. If you do not have a current mortgage then you are in a lucky position, and you will likely be able to take out a home equity loan without much difficulty. Those of us without such good fortune will need to subtract the amount of our mortgage from the appraisal value of our home, leaving us with a figure for the equity in our home. It's possible that you will find you have "negative equity" - that is, your mortgage is worth more than your house. You can end up in this situation even if you didn't take out a mortgage for more than the value of your home. Negative equity will often be a result of a declining housing market, where homes become less expensive. In this situation you have little hope of taking out another home equity loan.
Then there's your credit rating. It probably goes without saying that this little figure determines how much people will be willing to lend you, in home equity loans or otherwise. Credit ratings are compiled by a small handful of agencies, which gather information from lenders, court judgements, and other sources about your past performance in repaying debts. The more reliable you have been in the past, the better your credit rating will be, and so the higher will be your chance of getting a good home equity loan. Your credit rating will affect several aspects of a home equity loan: whether you are offered one in the first place, what interest rate you are offered - and, finally, what percentage of your equity you are able to borrow in a home equity loan. If you have a particularly good credit rating, you might be allowed to borrow up to perhaps 125% of the value of your house - that is, the lender will trust you so much that they are willing to lend you a quarter more than the amount they could reclaim by repossessing your house. If your credit rating is not so good, you might be limited to as little as 50% of the value of your home.
The last wildcard is the lender. Some lenders specialise in lending to people who might not be able to get loans elsewhere. These lenders expose themselves to higher risks of non-payment, and as such they tend to charge higher interest rates and impose higher fees. In the other corner are what we might call the blue-chip lenders, who will only lend to the most reliable people, and who, secure that their money will be repaid, can therefore offer better deals.
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