When you take out a home equity loan you're borrowing money from the equity in your house. In other words, you're borrowing money from yourself.
The interest rate and payments on home equity loans are fixed so it’s easy to plan for and budget. In order to get approved for a home equity loan you need to have adequate equity in your primary residence.
Here is a simple example of how home equity loans work.
Most banks will allow you to borrow up to 85% of your home’s current market value. For example:
- Market Value: $230,000 (an appraisal will be necessary to validate your home’s value)
- Loan to Value of 85%: $195,500 (maximum amount you can borrow against)
- Mortgage Balance: $175,000
- Max You Can Borrow: $20,500
If you opt for a home equity loan be smart about it. Home renovations and paying off high interest rate credit cards are two great reasons to apply for a home equity loan. Keep in mind it is a loan, and you'll have to make monthly payments to the the bank.
In addition to having adequate equity in your home (at least 20%) you should consider other factors in your decision when applying:
- Your credit score - this will determine what interest rate you pay
- Closing costs - can sometime be significant, consider how much you'll pay up front
- Prepayment penalties - if you pay the loan off in 3-5 years there might be a penalty
Conclusion - A home equity loan is a great way to make home improvement or pay off higher interest rate loans. Just make sure you're smart about how you spend the cash. Don't use the money to buy a home entertainment system or vacation for the family!