Definition
A home equity loan is an agreement between a lender and homeowner, whereby the loan is secured using the home as collateral. Home equity loans are sometimes referred to as second mortgages, which would be subordinate to any existing mortgage on the home.
Explanation
As the name implies, home equity loans use the equity in a home to secure a loan with a lender. Unlike a mortgage, a home equity loan cannot be used to purchase a home. These loans are structured like mortgages and personal loans and typically involve fixed rates and repayment terms that can be as long as 30 years. The loans are also written for a fixed amount, making them less flexible than home equity lines of credit.
Lending institutions will usually allow the borrower to take out a loan of up to 80% of the equity in a home. The amount of equity in a home is determined by taking the current market value of the home and subtracting all of the outstanding loans that are using the home as collateral.
As is the case with a mortgage, a home equity loan lowers the total amount of equity in a home. The interest charges associated with these loans is usually tax deductible. Since the home is used as collateral on the loan, if repayment is not made on schedule, foreclosure is possible.
Example
The market value of Elyssa's home is $500,000, and the remaining principal on her mortgage is $300,000. Elyssa would like to get her teaching degree, so she's looking for a home equity loan to help pay for school.
If her income allows, the lender has agreed to provide a loan up to 80% of the equity in the home. Elyssa's maximum loan would be calculated as:
= (Market Value of Home - Loans Using Home as Collateral) x 80%
= ($500,000 - $300,000) x 0.8 = $200,000 x 0.8, or $160,000
In this example, Elyssa could borrow up to $160,000 if her annual income supports an additional loan of that size.
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