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, and 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).
Example 1
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 five 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).
Example: Equity
| House purchase price: | $200,000 |
| Amount borrowed: | -$180,000 |
| Down payment/equity: | $20,000 |
Five years later
Amount borrowed: | $180,000 |
| Principal paid: | -$13,000 |
| Amount owed: | $167,000 |
| House's appraised value: | $300,000 |
| Amount owed: | -$167,000 |
| Equity | $133,000 |
Example 2
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 five years, you paid down $13,000 of your mortage debt.
As home prices fell and homes in your neighborhood went into foreclosure, your home's value dropped by 30 percent, 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: | $200,000 |
| Amount borrowed: | -$180,000 |
| Down payment/equity: | $20,000 |
Five years later
Amount borrowed: | $180,000 |
| Principal paid: | -$13,000 |
| Amount owed: | $167,000 |
| House's appraised value: | $126,000 |
| Amount owed: | -$167,000 |
| Equity | -$41,000 |
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, lines of credit defined ...
There are two 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 five and as long as 30 years.