What is a Home Equity Loan, and How Can You Use One?

There is an old saying some people use when they talk about their home, and it goes something like this, “A person’s home is their castle.” This phrase alludes to the fact that a person tends to think of their home as their sacred space, where they hold domain, and it’s their way or the highway. And why shouldn’t they? After all, homes aren’t cheap, and the fact that you’ve worked hard, saved, and sacrificed to afford your home should mean that you’ve earned the right to do with it what you please.

But while many people pour a lot of love and effort into their home, and invest their time and money to improve the design, decor, materials, and furniture that make up their home, few people take the time to think about what their home can give back in return. Sure, your house provides you a place to sleep comfortably, and keep the rain off your head, but is that all it can do? Is it possible that your home can actually help you get additional funds that you can use to improve it further, or use for something else in your life?

There is indeed an option that fits the scenario I just described. It’s called a home equity loan, and this guide will serve as both an introduction, and potential idea generator, to get your home working for you.

What is a Home Equity Loan?home loan

The first question you’re likely to ask at this point is, “Just what is a home equity loan?” A home equity loan is a type of secured loan in which you borrow money against the value of your home. Usually, home equity loans can be fairly easy to qualify for, and they can lead to a considerable sum that you can use to improve your house, buy a new car, take a vacation, or invest in some other way.

How Does a Home Equity Loan Work?

Home equity loans are based around the foundation of using your home as loaner insurance. In other words, when you agree to a home equity loan, you’re using your home as a form of collateral to both ensure that you get the loan, and the lender is protected against loss.

When you apply for a home equity loan, the lender is going to assess the value of your home, determine its current market worth, and then extend you a loan offer based on both the value of the home and how much equity you’ve build up.

What is Equity?

In layman’s terms, equity refers to how much ‘true ownership’ you have in your home. I know that seems confusing: you have the deed, take out homeowner’s insurance, and live there, so its your property, right? Not exactly.

Think about it like this: when you first purchased your home, it may have been worth $300,000. You may have paid $45,000, or 15% of the home’s value, as a down payment, but had to use a loan to cover the rest. In that respect, if you’ve just moved in, you only ‘truly own’ 15% of the property, and your mortgage lender owns the rest.

You build equity over time by paying off your mortgage, which gradually increases your ownership in the property. If you’ve paid an additional $105,000 towards your mortgage, on top of the $45,000 you made as a down payment, you now ‘own’ 50% of the home, or have 50% equity.

Constant changes in the real estate market can also increase your equity. Your home may have started at $300,000 in value, but over the years, it is now worth $600,000 (which isn’t likely, but it illustrates the point). You have $150,000 invested, from your down payment and mortgage payments, meaning your mortgage lender has a remaining $150,000 invested in the property, so you each have 50% equity based on the original value. With the ‘natural’ increase in value due to market conditions, that newly gained equity goes to you as the homeowner, so in reality, you now have 75% equity.

Typically, lenders are willing to extend anywhere from 80 to 90% of the equity you have in a home for a loan, so if you have 75% equity in a home valued at $600,000, a lender could potentially extend anywhere from $360,000 to $405,000 to you.

What are the Benefits?

With a home equity loan, you can get a very large sum of money all at once, and usually with a competitively low APR that you’ll have to pay back. As I mentioned earlier, home equity loans are usually easy to get approved for, and you can use your home equity loan for everything from pursuing a college degree to purchasing a new car.

As a final positive note, some states allow you to deduct some or all of the interest you pay on a home equity loan from your taxes, allowing you to save money in the long run. This is particularly true, in many cases, if you use invest your loan funds to improve your home even further.

What are the Risks?

The biggest and most obvious risk of taking out a home equity loan is the potential for losing your house. Since home equity loans hinge on using your home as collateral to ensure the repayment of the loan, you’re able to enjoy such a large sum, and reduced interest – there’s far less risk on the part of the lender, since they can just take your home if you default.

In addition, a home equity loan is like any other loan: regardless of how much you borrow, you’re going to have to pay it back, and in the time you’ve agreed to do so, or else you not only risk losing your home, but having your credit score suffer severely as well.

A final risk to consider: home equity loans are often referred to as a ‘second mortgage,’ because they have the exact same stipulation – if you don’t repay the loan, you lose your home. If you’re still repaying your mortgage, or don’t have a considerable amount of equity built up, it’s probably not in your best interest to take out a second, comparable, loan.