What is a Home Equity Loan and How Do They Work?

A home equity loan is a loan product offered to homeowners that have at least 80% equity in their property. The consumer uses the proceeds however they want and receive the full value at once. When approaching a lender about the products, consumers need to know further details about the products and how they work.

Understanding Credit Score Requirements

It is possible for applicants who have a credit score of 759 to 621 to get approved for the loans. However, when planning to use the loans, consumers get a better opportunity if they increase their credit score to 760. Approval for applicants with ratings under 759 happens, but the consumers pay higher than average interest rates and pay a lot more by the end of the contract. Preparing for the loan ahead of time gives them a better interest rate for their loan.

A Major Misconception

The lender looks at the consumer’s income-to-debt ratio when approving the loan. Consumers use the products to pay off debts. But, if their income-to-debt ratio is over 43%, then the lender cannot provide approval based on affordability. The major misconception is that as long as the consumer uses the loan to pay off the debts and they have equity then the lender guarantees them the loan. This is not the case at all.

Restricting the Loan Value

The first step for calculating the loan is determining how much equity the consumer has built up in their home. Equity is essentially the difference between how much the consumer has paid on the mortgage and how much they owe but with a few exceptions. What they don’t understand is that the current market value affects how much equity is available to them.

The lenders show them by calculating the current market value for the home and subtracting that value from what the consumer owes. A home that was valued at $100,000 originally but is now worth $200,000 offers the consumer equity. When calculating the equity, the lender multiplies the current value by 80% which is the current cap or restriction for most home equity and HELOC loans, as well as traditional mortgages . Next, the lender subtracts the remaining balance of the loan from the product of the calculation and reveals the highest equity loan value.

Tax Opportunities for Borrowers

Lenders explain that the borrower deducts the interest incurred when filing their tax returns if the loan is for renovations or home improvement opportunities. Some deductions might apply if the funds are used for health care purposes. However, the services must be for the taxpayer or a dependent.

Paying Off the Loan

The lender gives the borrower a choice for how long they take to pay the full loan balance. The programs range from 5 years to 30 years depending on the consumer’s preferences and the value of the loan. The total monthly payments are based on the duration of the loan and the interest rate applied. Since the loan is provided as a lump sum, some consumers place some proceeds into a saving account and use a surplus to pay the monthly payments.

About the author



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