Z What Is A Home Equity Loan

What Is a Home Equity Loan?
A home equity loan—also known as an equity loan, home equity

installment loan, or second mortgage—is a type of consumer debt. Home
equity loans allow homeowners to borrow against the equity in their
home. The loan amount is based on the difference between the home’s
current market value and the homeowner’s mortgage balance due. Home
equity loans tend to be fixed-rate, while the typical alternative, home
equity lines of credit (HELOCs), generally have variable rates.
KEY TAKEAWAYS
 A home equity loan, also known as a “home equity installment loan”

or a “second mortgage,” is a type of consumer debt.
 Home equity loans allow homeowners to borrow against the equity in
their residence.
 Home equity loan amounts are based on the difference between a
home’s current market value and the mortgage balance due.
 Home equity loans come in two varieties—fixed-rate loans and home
equity lines of credit (HELOCs).
 Fixed-rate home equity loans provide one lump sum, whereas
HELOCs offer borrowers revolving lines of credit.
How a Home Equity Loan Works
Essentially, a home equity loan is akin to a mortgage, hence the name
second mortgage. The equity in the home serves as collateral for the
lender. The amount a homeowner is allowed to borrow will be partially
based on a combined loan-to-value (CLTV) ratio of 80% to 90% of the
home’s appraised value. Of course, the amount of the loan and the rate of
interest charged also depend on the borrower’s credit score and payment
history.

Mortgage lending discrimination is illegal. If you think you've been
discriminated against based on race, religion, sex, marital status, use of
public assistance, national origin, disability, or age, there are steps you can
take. One such step is to file a report to the Consumer Financial Protection
Bureau or with the U.S. Department of Housing and Urban
Development (HUD).
Traditional home equity loans have a set repayment term, just like
conventional mortgages. The borrower makes regular, fixed payments
covering both principal and interest. As with any mortgage, if the loan is not
paid off, the home could be sold to satisfy the remaining debt.
A home equity loan can be a good way to convert the equity you’ve built up
in your home into cash, especially if you invest that cash in home
renovations that increase the value of your home. However, always
remember that you’re putting your home on the line—if real estate values
decrease, you could end up owing more than your home is worth.
Should you want to relocate, you might end up losing money on the sale of
the home or be unable to move. And if you’re getting the loan to pay off
credit card debt, resist the temptation to run up those credit card bills again.
Before doing something that puts your house in jeopardy, weigh all of your
options.
Special Considerations
Home equity loans exploded in popularity after the Tax Reform Act of
1986 because they provided a way for consumers to get around one of its
main provisions—the elimination of deductions for the interest on most
consumer purchases. The act left in place one big exception: interest in the
service of residence-based debt.
However, the Tax Cuts and Jobs Act of 2017 suspended the deduction for
interest paid on home equity loans and HELOCs until 2026, unless,
according to the IRS, “they are used to buy, build, or substantially improve
the taxpayer’s home that secures the loan.” The interest on a home equity
loan used to consolidate debts or pay for a child’s college expenses, for
example, is not tax-deductible.1
Before you take a home equity loan, be sure to compare terms and interest
rates. When looking, “don’t focus solely on large banks, but instead
consider a loan with your local credit union,” recommends Clair Jones, a
real estate and relocation expert who writes for Movearoo.com and
iMove.com. “Credit unions sometimes offer better interest rates and more-
personalized account service if you’re willing to deal with a slower
application processing time.”
As with a mortgage, you can ask for a good faith estimate, but before you
do, make your own honest estimate of your finances. Casey Fleming,
mortgage advisor at C2 Financial Corporation and author of The Loan
Guide: How to Get the Best Possible Mortgage, says, “You should have a
good sense of where your credit and home value are before applying, in
order to save money. Especially on the appraisal [of your home], which is a
major expense. If your appraisal comes in too low to support the loan, the
money is already spent”—and there are no refunds for not qualifying.
Before signing—especially if you’re using the home equity loan for debt
consolidation—run the numbers with your bank and make sure the loan’s
monthly payments will indeed be lower than the combined payments of all
your current obligations. Even though home equity loans have lower
interest rates, your term on the new loan could be longer than that of your
existing debts.

The interest on a home equity loan is only tax deductible if the loan is used
to buy, build, or substantially improve the home that secures the loan.
Home Equity Loans vs. HELOCs

Home equity loans provide a single lump-sum payment to the borrower,
which is repaid over a set period of time (generally five to 15 years) at an
agreed-upon interest rate. The payment and interest rate remain the same
over the lifetime of the loan. The loan must be repaid in full if the home on
which it is based is sold.
A HELOC is a revolving line of credit, much like a credit card, that you can
draw on as needed, payback, and then draw on again, for a term
determined by the lender. The draw period (five to 10 years) is followed by
a repayment period when draws are no longer allowed (10 to 20
years). HELOCs typically have a variable interest rate, but some lenders
offer HELOC fixed-rate options.
Advantages and Disadvantages of a Home Equity Loan

There are a number of key benefits to home equity loans, including cost,
but there are also drawbacks.
Obtaining a mortgage is a crucial step in purchasing your first home, and

there are several factors for choosing the most appropriate one. While the
myriad of financing options available for first-time homebuyers can seem
overwhelming, taking the time to research the basics of property
financing can save you a significant amount of time and money.
Understanding the market where the property is located, and whether it
offers incentives to lenders, may mean added financial perks for you. And
by taking a close look at your finances, you can ensure you are getting the
mortgage that best suits your needs. This article outlines some of the
important details first-time homebuyers need to make their big purchase.
KEY TAKEAWAYS
 Obtaining a mortgage is a crucial step in purchasing your first home

and there are several factors for choosing the best one.
 Lenders will evaluate your creditworthiness and your ability to repay
based on your income, assets, debts, and credit history.
 As you choose a mortgage, you'll have to decide between a fixed or
floating rate, the number of years to pay off your mortgage, and the
size of your down payment.
 Conventional loans are mortgages that the government does not
insure.
 Depending on your circumstances, you may be eligible for more
favorable terms through an FHA, VA, or other government-
guaranteed loan.
Loan Types
Conventional Loans
Conventional loans are mortgages that are not insured or guaranteed by
the federal government. They are typically fixed-rate mortgages. They are
some of the most difficult types of mortgages to qualify for because of their
stricter requirements—a bigger down payment, higher credit score, lower
income-to-debt ratios, and the potential for a private mortgage
insurance requirement. However, if you can qualify for a conventional
mortgage, they are usually less costly than loans that are guaranteed by
the federal government.
Conventional loans are defined as either conforming loans or

nonconforming loans. Conforming loans comply with guidelines, such as
the loan limits set forth by government-sponsored
enterprises (GSEs) Fannie Mae and Freddie Mac. These lenders (and
various others) often buy and package these loans, then sell them as
securities on the secondary market. However, loans that are sold on the
secondary market must meet specific guidelines in order to be classified as
conforming loans.
The maximum conforming loan limit for a conventional mortgage in 2021 is
$548,250, although it can be more for designated high-cost areas.1 A loan
made above this amount is called a jumbo loan, which usually carries a
slightly higher interest rate. These loans carry more risk (since they involve
more money), making them less attractive to the secondary market.2
For nonconforming loans, the lending institution underwriting the loan,

usually a portfolio lender, sets its own guidelines. Due to regulations,
nonconforming loans cannot be sold on the secondary market.
Federal Housing Administration (FHA) Loans

The Federal Housing Administration (FHA), part of the U.S. Department of
Housing and Urban Development (HUD), provides various mortgage loan
programs for Americans. An FHA loan has lower down payment
requirements and is easier to qualify for than a conventional loan. FHA
loans are excellent for first-time homebuyers because, in addition to lower
upfront loan costs and less stringent credit requirements, you can
make a down payment as low as 3.5%.3 FHA loans cannot exceed the
statutory limits described above.
However, all FHA borrowers must pay a mortgage insurance premium,

rolled into their mortgage payments. Mortgage insurance is an insurance
policy that protects a mortgage lender or titleholder if the
borrower defaults on payments, passes away, or is otherwise unable to
meet the contractual obligations of the mortgage.
VA Loans
The U.S. Department of Veterans Affairs (VA) guarantees VA loans. The
VA does not make loans itself, but guarantees mortgages made by
qualified lenders. These guarantees allow veterans to obtain home loans
with favorable terms (usually without a down payment). 4
In most cases, VA loans are easier to qualify for than conventional loans.
Lenders generally limit the maximum VA loan to conventional mortgage
loan limits. Before applying for a loan, you'll need to request your eligibility
from the VA. If you are accepted, the VA will issue a certificate of eligibility
you can use to apply for a loan.4
In addition to these federal loan types and programs, state and local
governments and agencies sponsor assistance programs
to increase investment or homeownership in certain areas.
Equity and Income Requirements
Home mortgage loan pricing is determined by the lender in two ways—both
methods are based on the creditworthiness of the borrower. In addition to
checking your FICO score from the three major credit bureaus, lenders will
calculate the loan-to-value ratio (LTV) and the debt-service coverage
ratio (DSCR) in order to determine the amount they're willing to loan to you,
plus the interest rate.5
LTV is the amount of actual or implied equity that is available in

the collateral being borrowed against. For home purchases, LTV is
determined by dividing the loan amount by the purchase price of the
home. Lenders assume that the more money you are putting up (in the
form of a down payment), the less likely you are to default on the loan. The
higher the LTV, the greater the risk of default, so lenders will charge more. 6
The DSCR determines your ability to pay the mortgage. Lenders divide

your monthly net income by the mortgage costs to assess the probability
that you will default on the mortgage. Most lenders will require DSCRs of
greater than one. The greater the ratio, the greater the probability that you
will be able to cover borrowing costs and the less risk the lender assumes.
The greater the DSCR, the more likely a lender will negotiate the loan rate;
even at a lower rate, the lender receives a better risk-adjusted return.
For this reason, you should include any type of qualifying income you can
when negotiating with a mortgage lender. Sometimes an extra part-time job
or other income-generating business can make the difference between
qualifying or not qualifying for a loan, or receiving the best possible rate.
Private Mortgage Insurance (PMI)

LTV also determines whether you will be required to purchase
private mortgage insurance (PMI). PMI helps to insulate the lender from
default by transferring a portion of the loan risk to a mortgage insurer. Most
lenders require PMI for any loan with an LTV greater than 80%. This
translates to any loan where you own less than 20% equity in the
home.7 The amount being insured and the mortgage program will
determine the cost of mortgage insurance and how it's collected.
Most mortgage insurance premiums are collected monthly, along with tax

and property insurance escrows. Once LTV is equal to or less than 78%,
PMI is supposed to be eliminated automatically. 8 You may also be able
to cancel PMI once the home has appreciated enough in value to give
you 20% equity and a set period has passed, such as two years.
Some lenders, such as the FHA, will assess the mortgage insurance as a
lump sum and capitalize it into the loan amount.

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What Is a Home Equity Loan?

A home equity loan—also known as an equity loan, home equity

 A home equity loan, also known as a “home equity installment loan”

Home Equity Loans vs. HELOCs

Advantages and Disadvantages of a Home Equity Loan

Obtaining a mortgage is a crucial step in purchasing your first home, and

 Obtaining a mortgage is a crucial step in purchasing your first home

Conventional loans are defined as either conforming loans or

For nonconforming loans, the lending institution underwriting the loan,

Federal Housing Administration (FHA) Loans

However, all FHA borrowers must pay a mortgage insurance premium,

LTV is the amount of actual or implied equity that is available in

The DSCR determines your ability to pay the mortgage. Lenders divide

Private Mortgage Insurance (PMI)

Most mortgage insurance premiums are collected monthly, along with tax

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