In order to understand how home equity loans work, you need to be familiar with certain concepts. Mainly, you should know what equity is and how it is calculated. Then, you will be able to understand why home equity loans provide such benefits and the risk that requesting this kind of loans implies.
Defining Equity
Equity is the difference between the value of an asset and the amount of debt that it secures. It is the remaining value of a property when the property's value exceeds the amount of debt that the asset guarantees. This equity can be used to secure another loan. Just like a home is used as collateral for a home loan, the same property (specifically its equity) can be used as collateral for a home equity loan or line of credit.
It is necessary to note that the value of the property to take into account is the appraised value of the asset (the current value) and not the purchase price of the property. The value that is taken into account is the amount of money you could get if you were to sell the property in the market.
Calculating Equity
In order to calculate equity you need to subtract any mortgages or liens hold against the property to the appraised value of the asset. For example: If you own a house worth $100,000 which has a mortgage loan with $60,000 of outstanding debt, the equity on your home is equivalent to $40,000. This remaining amount can be used to secure another loan.
Bear in mind that mortgages are not the only debts that can be subtracting value from your property, outstanding home equity loans, other liens and judicial embargos can reduce the amount of usable value of the asset. In order to correctly calculate the equity you need to consider all the above when subtracting the overall debt held against the property.
Benefits Of Home Equity
Home equity loans provide low interest rate financing compared to unsecured loans. The interest rate charged for home equity loans rarely exceeds 12% while the interest rate charged for unsecured loans can usually reach 18%, 20% or even more. The secured nature of home equity loans keeps interest rates low by reducing the risk involved in the lending process.
Home equity loans also offer higher loan amounts and longer repayment programs. This combination provides great flexibility as you can request significant amounts and obtain low monthly payments by extending the loan length. When it comes to unsecured loans not only you can not obtain high loan amount but you can not repay it throughout long repayment programs either.
Risk Of Repossession
The main concern that equity loans imply is that given that the loan is secured with your home, if you default on the loan you risk repossession of the property. Thus, whenever considering requesting a home equity loan, you should make sure that you will be able to repay the loan and that you put away some savings for unexpected expenses that otherwise may compromise loan repayment.
