What is a Home Equity Loan?

A home equity loan essentially means that you’re taking out a second mortgage on your house, based on the amount of equity you have in your home. A home equity loan is not to be confused be a “home equity line of credit”, which sounds similar but works in a very different way.

As aforementioned, a home equity loan uses your existing equity in your home as a form of collateral. For example, if your home is worth $500,000 and you have a mortgage that you owe $300,000 on, you thus have $200,000 of equity in the property. This means, in a sense, that you owe $200,000 worth of your property. Taking out a home equity loan against your home give you access to some of this $200,000 equity – this equity is a bargaining chip that you’ll never have for a conventional personal loan. Having access to this cash allows you to pay for expensive things such as college tuition funds or home improvement costs.

Home equity loans tend to have longer lifespans than conventional loans, and often last 10 or 20 years. You will usually pay a higher interest rate on a home equity loan than you will on a regular mortgage. This is because the bank that holds your initial mortgage has the “first rights” to claim your house as collateral if you do not make your payments on time. Meanwhile, the second lender (who gave you a home equity loan) has the “second rights” to claim your house as collateral. This, in a sense, makes a home equity loan “partially secured”, and this makes you riskier as a lender, thus resulting in higher interest rates.

In practice, home equity loans work similarly to regular fixed-term loans. In general, you will borrow a certain amount of money (usually at a fixed interest rate) and you will pay this money (and interest) back to the lender in regular monthly installments. These payments are stretched over a pre-arranged time period, lasting until the loan is completely paid off.

People often use home equity loans to consolidate lots of other existing loans (such as credit card debt) into one, easy-to-manage loan. People often do this with home equity loans because the interest you pay on them is typically lower than that of a credit card APR. However, bear in mind that if you miss your payments on your home equity loan, then your house is now suddenly at risk of repossession. Even though other debts (such as credit card debts) are bad, they cannot result in your home being repossessed. A credit card lender cannot directly take your home away from you, but a home equity loan lender can.

Home equity loans are often fairly lengthy loans that last a couple of decades and use some of your house as collateral. If taking out a home equity loan, be sure that it is the best option for you. Stretching out loans over time can often mean that you’re paying more in the interest over the long run (despite lower monthly payments) so always take this into consideration.