How Home Equity Loans Work

Home Equity Borrowing Basics
Trying to figure out how to cover the finances of a bathroom remodel? A second mortgage might be your answer.
Trying to figure out how to cover the finances of a bathroom remodel? A second mortgage might be your answer.
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There are a few different types of loans that allow you to use equity in your house as collateral. One type, the more traditional of the two, is known as a home equity loan or second mortgage. When you take out a second mortgage on your home, you are borrowing one lump sum of money from the bank. You will be required to pay back the loan over a fixed period of time at a designated interest rate. For a project like a remodel or renovation, where you've gotten an estimate from the contractor and you know what you need, a second mortgage is a good idea.

Now that you understand the basics, let’s take a closer look at equity.

About Equity

As we mentioned earlier, borrowers have several options when it comes to borrowing against the equity of their home -- a home equity loan (also commonly called a second mortgage), a home equity credit line (also called a HELOC) and a reverse mortgage. A home equity loan or second mortgage is based off of equity, or the amount of value you have in your house. Because homes generally appreciate in value over time, equity is calculated by taking the difference between the current worth of your home and how much you owe on your initial mortgage. Say you bought your house for $350,000 and you have paid off $175,000 of a $300,000 mortgage. A recent appraisal puts your home’s value at $500,000. You would calculate your current equity in your house like this:

$500,000 - $125,000 = $375,000

The $125,000 number is the amount of money yet to be paid on your mortgage. And because your house has appreciated in value -- somewhat like a stock or a valuable antique -- so has your equity in your home increased. In many cases, you may be able to use this investment to borrow against your equity in order to get another loan. And just like with your first mortgage, your house serves as the collateral that guarantees your loan to the bank. If you can’t pay off your second mortgage, you may be forced to sell your home, or the bank might seize it.

Frequently, the length of a second mortgage is shorter than the first, though they can last anywhere from five to 30 years. Still, second mortgages are generally intended to be for smaller amounts than the first, for consolidating debts, financing an addition to a home or helping to pay for a child’s college tuition. But in some cases, homeowners simply wish to take advantage of a good investment by borrowing against the rising equity of their home and thereby gaining some financial flexibility.

As home ownership has grown in the United States, so has mortgage debt.