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What Is a Home Equity Loan and How Does It Work?

By Jarrod Heil

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If your home has substantially increased in value or you’ve paid off a decent chunk of mortgage, you could be sitting on a pile of cash you never knew you had.

But just because that pile of cash is available at your fingertips for the taking, that doesn’t mean you should take it. After all, you’d be borrowing against your home and would be required to pay it back in full.

Before taking out a home equity loan, you need to understand what it is, consider your options and then figure out if it’s a good fit.

We’ll break down everything you need to know about home equity loans so you never again have to wonder “what is a home equity loan and how does it work.”

What Is a Home Equity Loan?

A home equity loan is essentially a second mortgage you take out on the equity you’ve built up in your home over time. It allows you to borrow against home equity, which is the difference between the value of your home and the amount you owe on your home, while paying very low interest.

How Does a Home Equity Loan Work?

Home equity loans work very simple in nature. If your home is valued at $250,000 and the balance of your mortgage is $200,000, you can borrow up to $50,000 in a home equity loan. You’ll be guaranteeing your loan using your home, though, so if you fail to pay your loan payments, you could potentially lose your home to foreclosure.

It works like this:

Let’s say you need $30,000 to get your roof replaced, but you don’t have $30,000 in cash lying around, and you definitely don’t want to put that much on your credit card or secure a personal loan for the said amount because the interest on both is way too high. What can you do?

If your home is worth $250,000 and your mortgage balance is $200,000 (like in the previous example), that means you can borrow up to $50,000 with a home equity loan. If you borrow that amount, you won’t receive the $50,000 as a lump sum of cash. You’ll receive it as a line of credit to borrow from whenever you need extra cash — in this case $30,000 for a new roof.

When you borrow the $30,000 for a new roof, you’ll receive the loan at a low interest rate (anywhere from 3 percent to 10 percent). Like a credit card, you’ll need to make a minimum monthly payment each month, but unlike a credit card, you’ll need to pay the loan in full eventually to eliminate the loan.

With home equity loans, you’re borrowing against the equity in your home, so you’re basically using your home as collateral in case you fail to pay. If you fall behind or fail to pay the loan’s minimum payment, the bank can come in and take your home, forcing you into an unexpected foreclosure.

Also unlike a credit card, your lender can cancel or freeze your line of credit if the value of home decreases or they’ve detected a change in your financial situation, such as losing a job or racking up extra credit card debt.

How Do I Get a Home Equity Loan?

Getting a home equity loan is just like getting a credit card or another form of loan. All you need to do is apply for a loan with your current lender, or whichever lender is offering the best rates. Once you’re approved for the line of credit, you can start borrowing against your home’s equity instantly.

Is a Home Equity Loan Worth It?

Every person has a unique situation, so while getting a home equity loan may be worth it for people, it may not be worth it for others. If you have disposal cash in the bank and don’t mind spending it, you may be better off spending it rather than getting a home equity loan.

On the flip side, if you need to spend a great deal of money you don’t currently have (such as on replacing a roof or another necessity in life), taking out a home equity loan is a solution that offers lower interest rates than traditional borrowing methods.

Should I Get a Home Equity Loan?

Similar to the statement above, you need to evaluate your personal situation to decide if getting a home equity loan is the right decision for you. If you feel a home equity loan would ease the financial burden and help you out in the long term, just make sure you pay it off properly.