What is a home equity loan?

Home equity loans are a popular choice for people looking to access a large sum of money with relative ease and at a favourable rate. When done right, home equity loans can be a smart tool you can use to build wealth over time.

Of course, there’s no such thing as a free lunch. Let’s first try to dissect a few of the intricacies that make up this cash-injecting instrument.

What is home equity?

Let’s start with what “home equity” actually is, before we get to the loan part.

Your home is a conservative investment. In most real estate markets, its value should gradually increase over time. Fluctuations will happen along the way, but not wildly, like riskier investments tend to do. This increase is called equity, and it’s all yours — almost.

Before we get into the nitty-gritty, here’s a simple way to calculate your home’s equity:

Current market value of home – what you owe = home equity.

Remember that the market value is what someone is willing to pay for your home. Assessed value is what your property taxes are based on — don’t confuse the two.

For example:

Say you have $50,000 left to pay on your mortgage, and the current market value of your home is $400,000. This leaves you with $350,000 in home equity.

Got it? Great! Let’s move on.

There are two ways your equity can increase:

• The market value goes up

• The principal balance of your mortgage goes down (from payments)

If you’re one of the lucky ones to have built up a sizable amount of home equity, then you have the option to either leave it alone or tap into it. A home equity loan is one way to tap into your home’s equity.

What’s a home equity loan?

Also referred to as a second mortgage or an equity loan, a home equity loan is an agreement between a homeowner (borrower) and a lender (bank).

How it works:

• The homeowner receives a lump sum of cash, and the lender receives interest on that sum over the course of the loan’s life.

• The home serves as collateral for the loan, which makes it a “secured loan,” and typically comes with lower interest rates than other types of loans.

Under the terms of the agreement, the borrower must:

• Complete an application process and get approved, with determining factors like:

  • Home equity percentage

  • Credit score

  • Debt-to-income ratio

• Agree to pay the loan back in fixed installments (principal and interest) over a predetermined period of time; or

• Face penalties, and possibly foreclosure, if they fail to honor the agreement

In exchange, the lender:

• Sets the terms of the agreement: the interest rate, length of term (typically 5 to 30 years), amount lended (up to 80% of home’s equity)

• Makes money from the interest that accrues on the loan value (received in payments from the borrower)

• Has the right to penalize the borrower for not honoring the terms of the agreement, or possibly foreclose on the property if the borrower defaults (cannot pay the loan back)

"Your home is a conservative investment. In most real estate markets, its value should gradually increase over time."

What are some good reasons to take out a home equity loan?

Home equity loans work best when they are used for purposes that strengthen your financial situation.

Home renovations

Let’s say you want to renovate your kitchen that looks like it came from the set of a 90’s sitcom. You know this is a good investment, because the Property Brothers on HGTV told you repeatedly that “kitchens and baths sell homes.”

You expect these updates to cost you around $30,000, but you don’t have that type of money laying around, so you begin to explore your options. You then recall that your neighbor put an addition on their house by tapping into their home’s equity, and eventually discover that you could do the same.

You decide to apply for a home equity loan to access the capital needed for the renovation; you get approved; and, voilà, you get a new kitchen and (hopefully) a more valuable home. And if you play your cards right, you may even qualify for a tax deduction on the interest.

This is just one way you can use a home equity loan to better your financial situation.

Some other reasons you might want to look into a home equity loan include:

• Consolidating debt: You may be able to pay off debts that have higher interest rates than the home equity loan, leaving you with just one (lower interest rate) payment to worry about, rather than several.

• Tuition for university: Got kids who like to learn? Weigh your options — a home equity loan might be a better alternative to pay for school than student loans that come with higher rates.

• Emergency fund: Nothing beats a  good old-fashioned savings account, but for those who want to seek an alternative option, a home equity loan can serve as a feasible slush fund.

What are some bad reasons to take out a home equity loan?

Since home equity loans are there to virtually “use as you wish,” some folks may use them for the wrong reasons. Don’t be that person.

Here are some reasons to NOT take out a home equity loan:

• To replace income: If you don’t have enough income to pay your “normal” bills and to live comfortably, then you certainly should not take out more credit to remedy the situation. This will just put you further in debt, adding on another monthly bill.

• To buy a car: Cars aren’t investments, unless they are collectibles – but even then, the market for them is thin. Most cars heavily depreciate in value and are not worthy reasons to take out a home equity loan.

• To pay for a vacation: If you can’t afford a trip on your income and/or savings alone, then consider starting your savings journey now, instead of seeking a home equity loan.

• To help out a friend or family member: As nice as it may seem, and as trustworthy as they may be, this is risky business. What if they can’t pay you back?

The key thing to remember here is: if it’s frivolous or can put you in a worse financial situation, don’t do it. Simple, right?

"Home equity loans work best when they are used for purposes that strengthen your financial situation."

What are the risks of taking out a home equity loan?

Just about everything in life comes with a risk or two, and a home equity loan is no exception. Know the risks before taking the plunge.

Your home is on the chopping block

Remember, you are putting your home up as collateral. If you default on the loan agreement, you might have to bid your home adieu. This is what makes it different from other debt instruments like credit cards, where the worst thing that could happen is you get buried in fees and your credit score tanks.

Make sure you have the income to cover the payments, or risk not having a place to lay your weary head at night.

Your home value may decrease

Sure, the Candian housing market has been booming lately, but what happens if that bubble bursts? One possibility is that you become “upside-down” on your mortgage. Sounds painful, right? This happens when you owe more on your mortgage than the fair market value of your house. Quite a sticky situation, indeed.

Avoid this by preparing for the worst – or risk the chance of standing on your head for the foreseeable future.

Your credit score may fall

To many, their credit score is like their baby. They check on it (all too often) to make sure it’s safe and hasn’t fallen, do everything in their power to keep bad influences at bay, and defend it to their grave.

The bad news is, your beloved metric may be in danger when you take out a home equity loan. Since the lump sum you receive is so large, creditors see this as a risky move. After all, this is additional credit you are taking out. If you overextend your credit limits, you risk losing some valuable points.

Fortunately, there are various credit building products out there (ahem, like KOHO’s very own Credit Building feature). So, if you decide taking out a home equity loan is the right call, but are hesitant about its effects on your credit score — fret not! There are tools to build your credit history before you take out the loan to lessen its blow, or afterwards, to remediate your situation.

Any strings attached?

We all need fast money every now and again, and home equity loans can be an enticing “sleeping giant” to awaken when you need it most. After all, who doesn’t love the feel of a sack of cold hard cash in their hands?

But, as enticing as it may seem, there’s no such thing as free money – even if it is technically yours. So, be sure to examine all of the strings that are attached to a loan, or you might just find yourself on the outside, looking in.