What is a Home Equity Loan?

Home equity is the amount of money that you have sealed in your home by making payments on your mortgage. The equity is the difference between the current market value of a home and how much money is left owing on the principal of a mortgage. The equity is the money that you have paid that has been applied to the principal (original amount) of the mortgage.

A home equity loan is a loan that a home owner takes out; using the equity he/she has built in their home as collateral for the loan. A home equity loan is also known as a second mortgage. The term of the home equity loan is usually much shorter than the primary mortgage and is usually paid off in one to five years.

Home equity loans are typically more risky for lenders to offer because if the borrower defaults on their payments to the lender, the original mortgage is paid out first—which is why second mortgages are only given for the total amount of equity built into the home. This typically means that the interest rate on the second mortgage will be higher than a traditional, or first, mortgage.

There are many reasons for people to take out a home equity loan. Some basic reasons are to finance home repairs or renovations, pay off medical bills or pay for children’s college educations.

If you are taking a home equity loan to repair or renovate your home, you are in good stead with the bank, because by doing repairs or renovations to your home, you are increasing the value of the home to the same, or more, than the current market value. Some home equity lenders will allow a margin percentage above the equity built in your home for a loan if the money will be used for renovations. However, you will need to have solid plans in place for renovations, and may even have to sign a contract that you will indeed use the money for home renovations and improvements.

In most cases, in order to get a home equity loan, you will have to have good credit history, especially with the primary mortgage payments and a decent loan-to-value ratio—meaning that the ratio of money owed on the home is reasonable compared to the value of the home.

Home equity loans generally come in two types—open end home equity loans and close end home equity loans.

A closed end home equity loan is when the borrower of the home equity loan receives a lump sum of money and can’t borrow any more money off the value of their home. Most commonly, you can borrow up to 100 per cent of the home equity, although in some cases you can get marginally higher percentages, especially for renovations—known as an ‘over equity loan’.

An open end home equity loan is revolving credit, which is known more commonly as a home equity line of credit. In this case, the borrower can choose how often and when they borrow against the equity of their home. The lender will generally set a limit to the credit line, up to 100 per cent of the equity. The minimum payment can be as low as the interest that is due on the home equity line of credit.