Home equity loan explained

For some people, the term home equity is confusing. So let’s use a few examples to explain home equity.   When you purchased your home, you probably made a down payment. The down payment may have been as low as 3% or as large as 20% or more. Let’s assume you purchased the home for $100,000 and made a 5% down payment ($5,000) and your  interest rate was 6% for a 30 year term. In this example, your “home equity”, would look like this:
5% home equity

You have 5% ownership in the home or 5% “equity” ($5,000). The bank owns 95% of the home. After a few years of making mortgage payments, your “equity (ownership) grows to approximately $11,598.36 ($5,000 down payment + $6,598.36 additional equity from paying down on the mortgage).

10% home equity

But after 5 years, not only did you reduce the amount that you owe the bank, but the house has increased in value (hopefully). The home may now be worth $110,000. So the equity in the home is the down payment ($5,000) plus the amount you paid down on the mortgage ($6,598.36) plus the increase in value ($10,000).  

Down payment = $5,000
Mortgage payments = $6,598
Increase in value = $10,000
Your Total Equity = $21,598

Home equity in the house

The home equity is the difference between the current home value, less the balance of the mortgage, if any.  

Current value = $110,000
Less mortgage balance =  $88,401.64
Your Total Equity = $21,598

What is a home equity loan?  

Now that you know what the term home equity is, let’s learn about equity loans. A home equity loan is a loan against the amount of equity that is available. In the previous example, the homeowner had achieved $21,598 equity (or ownership) after 5 years.

After owning a home for some period of time, homeowners need money for home improvements, unforeseen expenses or find that a home equity loan is a good way to consolidate credit card debt. Here’s how a home equity loan works . . .  

The home equity loan requirements vary from lender to lender and from state to state. Using the previous example, a bank might loan the homeowner half of the available equity in the home ($10,799). Most home equity lenders will only lend a percentage of the total equity. There a several reasons for not lending up to the total equity of the home. One reason is that the appraiser or value estimator could over value the property. Another reason, and the most important reason, is that if the bank would have to foreclose on the homeowner, the bank can sell the home for less than the total value of the home (Sales price less the balance of the first mortgage and home equity loan).

Are home equity loans a good idea?  

Home equity loans are a good idea for many homeowners. Home-equity loans can be used for debt-consolidation. Paying off credit card debt with a home equity loan can often lower the total credit card monthly payment(s) because the total credit card debt can be spread over a longer term and at a lower interest rate with a home equity loan. The interest rates on home equity loans are usually lower than credit card interest rates. The reason banks are able to offer a lower interest rate with a home equity loan is because the homeowner is putting up the home as collateral. If the homeowner fails to make the home equity payment, the bank can sell the house by foreclosing on the homeowner.