What it means
Equity is simply the property's market value minus what is still owed on it. A lender will let you borrow against part of that equity, up to a combined loan-to-value limit that usually sits somewhere between 80% and 90% of the property's value including the existing mortgage.
That limit, not your equity in full, is what caps the loan. The attraction for borrowers is cost and predictability.
Because the debt is secured, rates are typically several percentage points below a personal loan and far below a credit card, and a fixed rate with a fixed term means the monthly payment does not move. Business owners sometimes use this route to fund a venture when commercial credit is unavailable or slower to arrange.
The risk is that you have converted unsecured obligations into a claim on your home. Consolidating credit card balances into a home equity loan lowers the monthly cost, but it also turns a debt that could at worst damage your credit record into one that can cost you the roof over your head.
Stretching a five-year debt over fifteen years also increases total interest even at a lower rate. Two features are worth checking before signing.
The loan sits behind the first mortgage in priority, which is why it is sometimes called a second charge or second lien, and that subordinate position is part of why the rate is higher than the primary mortgage. Costs such as valuation, arrangement and legal fees also need to be added to the comparison, because they can materially change the effective rate on a smaller loan.
In practice
Real-world examples.
Example
A couple with $220,000 of equity borrows $60,000 at 7% over ten years to replace a roof and rewire their house. They accept the secured debt because the work protects the value of the asset they are borrowing against, and the fixed payment fits inside their existing budget.
Example
A restaurant owner cannot obtain a commercial loan for a second site and borrows $90,000 against her home instead. Her adviser insists she model the payment against her worst three months of trading, not her average, because the loan must be serviced whether or not the new site performs.
Example
A homeowner consolidates $35,000 of credit card debt at 22% into a home equity loan at 8%, cutting the monthly cost substantially. His adviser sets one condition: the cards are closed, because otherwise the balances typically rebuild within two years and the household ends up with both debts.
Think of it
“Home equity loan borrows against your home's value-second mortgage.
Formula
Calculation
Available equity = (property value x maximum combined loan-to-value) - existing mortgage balance. Monthly payment = P x r / (1 - (1 + r) to the power of -n), where P is the loan amount, r the monthly interest rate and n the number of months.
A house is worth $480,000 with an outstanding mortgage of $300,000, so the owner's equity is $180,000. The lender allows a combined loan-to-value of 85%: 0.85 x $480,000 = $408,000, minus the $300,000 mortgage leaves a maximum home equity loan of $108,000.
The owner borrows $100,000 at 7.5% over 15 years. The monthly rate is 0.075 / 12 = 0.00625 and the term is 180 months, giving a payment of about $927.01 a month. Over the full term that is 180 x $927.01 = $166,862, of which $66,862 is interest, a figure worth weighing against whatever the money is being used for.Case study
Seen in the real world.
This case is illustrative and fictional. Delia Marchetti, an invented small business owner, had a home worth $520,000 with $240,000 outstanding on her mortgage, and wanted $85,000 to buy equipment for her catering firm.
Her bank declined a business loan on the grounds of a short trading history, so she took a home equity loan at 7.25% over twelve years, costing roughly $860 a month. The equipment lifted her capacity enough to add about $4,000 a month in gross profit, which comfortably covered the payment.
In this fictional account, her accountant made her write down what would happen if revenue fell by 40% for six months. The answer was that the loan was still serviceable from household income alone, and that test, rather than the return on the equipment, was what made the decision defensible.
Watch out
Common mistakes.
- Borrowing against equity as though it were savings. Equity is not spare cash; drawing on it creates a new monthly obligation secured against the place you live.
- Comparing only the interest rate when consolidating debt. A lower rate over a much longer term can cost more in total interest, so compare the total amount repayable, not just the monthly payment.
- Overlooking fees on smaller loans. Valuation, arrangement and legal costs of a few thousand dollars are a small percentage of a $200,000 loan but a significant one on a $25,000 loan.
Questions
People also ask.
What is the difference between a home equity loan and a HELOC?
A home equity loan pays a lump sum at a fixed rate with fixed instalments, while a home equity line of credit works like a revolving facility you draw on as needed, usually at a variable rate.
How much can I usually borrow?
Most lenders cap total borrowing against the property at 80% to 90% of its value including the existing mortgage, so the available amount is that limit minus what you already owe.
What happens if property values fall after I borrow?
The loan balance does not change, so you may end up owing more than the property is worth, which limits your ability to sell or refinance until values recover or the balance is paid down.
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