What You Need to Know About Home Equity Loans
Interested in remodeling your kitchen or bathroom? Perhaps you need extra help paying off a credit card? A home equity loan can assist you.
How does a home equity loan work? You might think that researching and shopping for the right loan can be overwhelming, but we're here to help! In this article, you'll get a 360 degree understanding of a home equity loan by:
- Outlining several examples used with a home equity loan
- Breaking down how to use a 1st lien home equity loan to refinance your current mortgage and get cash for home improvements
- Showcasing 4 main benefits of a home equity loan
Plus, we’ll cut through all the jargon, too. This way, when you’re ready to start shopping for a loan or meet with a lender, you’ll have enough knowledge to confidently choose the right loan for you.
How can a home equity loan help you?
In its simplest definition, a home equity loan is a way to borrow money when you own a home. If you think you’ll need to borrow funds, first you need to get clear on why. Let’s go through a few scenarios where a home equity loan can make your life easier.
- Home improvements. Whether it’s needing a new roof, upgrading the bathroom, or any other remodeling project meant to increase the value of your home.
- Large, unexpected expenses. This can include a medical emergency that has the potential to wipe out or surpass any savings.
- Debt consolidation. Credit card interest payments can hurt financially and a home equity loan can help you pay it down to limit the impact of interest.
- Refinancing your existing mortgage. By using a 1st lien home equity loan you can get a more affordable mortgage. In the next section, we’ll go more in-depth with this example.
These four examples are among the most common uses for a home equity loan. When you have a project in mind, a trusted bank can point you in the right direction. To prepare you for that moment, we’ll define and cover the requirements for a home equity loan using an example.
Breaking down a home equity loan
Earlier we mentioned a home equity loan is about borrowing funds. But there’s a bit more involved. Let’s break down how it works with an example specific to refinancing with a 1st lien loan.
A home equity loan leverages the equity of a home to receive a personal loan at an affordable interest rate. Essentially you’re borrowing money against the asset you own. Additionally, a 1st lien loan takes the place of the original mortgage. - Dollar Bank
Day 1 - Purchasing your home
Danny and Maria purchased their home on Mulberry Lane in 2010 for $200,000. This adorable cottage was the affordable starter home they were looking for.
- The value of this home is $200,000, also known as the purchase price.
- Danny and Maria were approved for a home mortgage with a 20% down payment. This means at closing, the couple paid $40,000.
- The $40,000 down payment can also be referred to as equity, or how much of your home you truly own.
- A mortgage is the result of the purchase price minus the down payment. Therefore, Danny and Maria work to pay off a $160,000 mortgage.
- With a 5% fixed interest rate, the couple’s monthly payments come to around $1,100.
A fixed interest rate means the interest on your monthly payments will not vary. If you’re interested in learning how much equity you have in your home, you can calculate it here. - Dollar Bank
Year 10 - Pre-refinance
Over the last few years, the value of their home increased to $250,000 as the neighborhood became a highly sought after place to live. On a resale value, the increased worth is good news.
Now in 2020, Danny and Maria’s situation has changed. The pair has two kids and want to stay in their house for at least another 5 years. They’ve also done the research and discovered interest rates are much lower today than they were ten years ago.
- Danny and Maria are looking to refinance their mortgage for two reasons: to take advantage of a lower interest rate, and to do home improvements too.
- After 10 years, the couple paid $32,000 off their mortgage, also known as the paid principal.
- To start their mortgage was $160,000. They paid $32,000, which means as of now the mortgage is $128,000.
- Their equity is the original down payment plus the paid principal. This would be the $40,000 down payment plus the $32,000 paid principal, which makes the equity now $72,000.
Year 10 - Refinancing
It’s time to refinance with a home equity loan! Danny and Maria are ready to visit their bank to learn more about how a loan can work for them.
Remember, the home value for Danny and Maria increased to $250,000, and a 1st lien home equity loan amount is based on 80% of the home value. They qualify for a $200,000, 20-year term with a 3.5% fixed interest rate.
A term or fixed rate loan means you’re looking to borrow one large, lump sum of money and your payments will be the same amount each month. - Dollar Bank
With a 1st lien home equity loan of $200,000, the couple will be able to immediately pay off the remaining, original mortgage balance of $128,000 in a lump sum payment. Their home equity loan becomes their new mortgage loan.Then they will also have $72,000 left in cash.
To summarize, after refinancing and securing a 1st lien home equity loan, Danny and Maria have a new home value of $250,000, a loan for $200,000, equity in the home worth $50,000 (250,000 home value minus $200,000 loan amount), and $72,000 to make improvements.
Keep in mind, even if they invest $72,000 in a dream kitchen or other improvements this doesn’t necessarily mean that their home’s value will increase by $72,000. If the house you’re currently living in is not your forever home, it’s best to make functional improvements over dream improvements. According to money-management expert Dave Ramsey, home improvement projects that add value can be categorized as the following:
- If you plan to stay in your home , “You’ll do a little better with the return on your investment if you remodel unused areas like your attic or basement into living spaces.”
- If you’re looking to sell , a project like “replacing your front door with a new steel entry door has had the best return on investment (ROI).”
- Maintain invisible improvements like a cooling unit, hot-water heater, or a septic system because “if any of these invisible parts of your home aren’t in working order, it will detract big time from your home’s value.”
Reap the benefits of a home equity loan
Let’s weigh the pros of a home equity loan. Understanding the benefits can help you set expectations on the process itself as well as how to utilize this kind of loan to its full potential.
- Options for a home equity loan typically have little to no closing costs. Some lenders may allow closing costs to be financed as part of the loan rather than upfront or out-of-pocket cost.
- Private Mortgage Insurance is not typically required to receive a home equity loan .
- Home equity loans may offer the ability to borrow up to 90% Loan-to-Value of your home.
- When it comes to the loan term, home equity loans can go up to 20 years and potentially longer, which can help keep monthly payments affordable.
Knowledge is power and helps you feel confident when making decisions! After covering what a home equity loan can do for you, and understanding how one works, you should be able to finance your projects with ease.
There are many lenders available that offer home equity loans. However, when gathering information from these lenders, it’s important to understand which are truly on your side.
Dollar Bank representatives don’t take sales commissions, which means they have the sole purpose of finding the best loan for you, not the bank. You can learn more about working with a non-sales commission representative here.
Posted: September 03, 2020