Home equity debt: What is it and how can you make it work for you?
A home equity loan or line of credit allows you to borrow money using your home’s equity as collateral.
Wait. Don’t click to another page. If the above paragraph seems like gibberish, you have surfed to the right place. We will explain:
- What home equity is.
- What collateral is.
- How these loans and lines of credit work.
- Why people use them.
- What pitfalls to avoid.
First, some definitions:
Collateral is property that you pledge as a guarantee that you will repay a debt. If you don’t repay the debt, the lender can take your collateral and sell it to get its money back. With a home equity loan or line of credit, you pledge your home as collateral. You can lose the home and be forced to move out if you don’t repay the debt.
Equity is the difference between how much the home is worth and how much you owe on the mortgage (or mortgages, if you have a home equity loan or line of credit).
Let’s say you buy a house for $200,000. You make a down payment of $20,000 and borrow $180,000. The day you buy the house, your equity is the same as the down payment ($20,000):
$200,000 (home’s purchase price) – $180,000 (amount owed) = $20,000 (equity)
Fast forward 5 years. You have been making your monthly payments faithfully and have paid down $13,000 of the mortgage debt, so you owe $167,000. During the same time, the value of the house has increased. Now it is worth $300,000. Your equity is $133,000:
$300,000 (home’s current appraised value) – $167,000 (amount owed) = $133,000 (equity)
House purchase price
In the housing meltdown that began in 2006, many homes lost equity rather than gained it. Instead of increasing, the value of the house dropped after the home was purchased. In many instances, a home equity loan would not be available.
Using the above example, let’s say you buy a house for $200,000. You make a down payment of $20,000 and borrow $180,000. During the next 5 years, you paid down $13,000 of your mortgage debt.
As home prices fell and homes in your neighborhood went into foreclosure, your home’s value dropped by 30% (or $54,000) to $126,000. Because the value of your home is less than the amount you owe, you have $41,000 in negative equity and would not be eligible for a home equity loan.
Example: Negative equity
House purchase price
House’s appraised value
A home equity loan (or line of credit) is a second mortgage that lets you turn equity into cash, allowing you to spend it on home improvements, debt consolidation, college education or other expenses.
Equity loans and lines of credit defined
There are 2 types of home equity debt: home equity loans and home equity lines of credit, also known as HELOCs. Both are sometimes referred to as second mortgages, because they are secured by your property, just like the original (or primary) mortgage.
Home equity loans and lines of credit usually are repaid in a shorter period than first mortgages. Most commonly, mortgages are set up to be repaid over 30 years. Equity loans and lines of credit often have a repayment period of 15 years, although it might be as short as 5 and as long as 30 years.
A home equity loan is a one-time lump sum that is paid off over a set amount of time, with a fixed-interest rate and the same payments each month. Once you get the money, you cannot borrow further from the loan.
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A home equity line of credit. or HELOC, works more like a credit card because it has a revolving balance. A HELOC allows you to borrow up to a certain amount for the life of the loan — a time limit set by the lender. During that time, you can withdraw money as you need it. As you pay off the principal, you can use the credit again.
Let’s say you have a $10,000 line of credit. You borrow $5,000 to pay for new kitchen cabinets. At that point, you owe the $5,000 you borrowed, and you have $5,000 remaining in your credit line, meaning that you could borrow another $5,000.
Instead of borrowing more from the line of credit, you pay back $3,000. At this point, you still owe $2,000, and you have $8,000 in available credit.
A HELOC gives you more flexibility than a fixed-rate home equity loan. It also is possible to remain in debt with a home equity loan, paying only interest and not paying down principal.
A line of credit has a variable-interest rate that fluctuates over the life of the loan. Payments vary depending on the interest rate, the amount owed and whether the credit line is in the draw period or the repayment period.
During the equity line’s draw period, you can borrow against it and the minimum monthly payments cover only the interest, although you can elect to pay principal.
During the repayment period, you can’t add new debt and must repay the balance over the remaining life of the loan.
The draw period often is 5 or 10 years, and the repayment period typically is 10 or 15 years. Those are generalizations; each lender can set its own draw and repayment periods. Lenders have been known to have draw periods of 9 years, 6 months, and repayment periods of 20 years.
A line of credit is accessed by check, credit card or electronic transfer (ordered by phone). Lenders often require you to take an initial advance when:
- You set up the loan.
- Withdraw a minimum amount each time you dip into it.
- Keep a minimum amount outstanding.
With either a home equity loan or a line of credit, you have to pay off the balance when you sell the house.
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