The idea of a home equity loan seems fairly self-explanatory — it’s any loan that’s secured against the value of your property. At first glance this might sound a lot like a mortgage, however, they’re not always the same thing. But what’s the difference between a home equity loan and a mortgage?
For starters, a mortgage is used to pay for the initial purchase of a property. A home equity loan, on the other hand, can be used for just about anything, depending on the terms and the amount of the loan.
How Does a Home Equity Loan Work?
To understand how a home equity loan works, it’s important to understand just what home equity is. In a nutshell, equity is the appraised value of your home, minus any outstanding payments on your mortgage, or other existing home equity loans.
Let’s say you purchase a home for $500,000. When you buy it, you put down $100,000 as a down payment, and you’re approved for a mortgage worth $400,000. At the time of that purchase, your home has 20 percent available equity, since your down payment represents 20 percent of the home’s total value.
As you pay off your mortgage, your home’s equity increases. Say 15 years down the line you’ve paid off another $200,000. Now your total equity is around $300,000, or 60 percent of the home’s original $500,000 value.
As you probably know, the real estate market is in constant flux, and the market value of a home can change from year to year. The good news is that if your home appreciates, that value is added to the equity. Say in the 15 years since you purchased your home, its value has increased to $800,000. You still owe $200,000 on the mortgage, but your available equity has now doubled, and represents 75 percent of the home’s total value.
When you apply for a home equity loan, the lender or broker will look first at how much available equity you have. They’ll use this to determine the size of the loan that you’re eligible for. You can’t get a home equity loan that’s worth more than the available equity in your home — in the above example, the maximum amount of the loan you would be eligible for would be $600,000.
That said, the majority of home equity loans are a lot smaller, because they tend to be used for smaller expenses — things like renovations, business costs, paying off credit card debt, and in some cases, covering continued mortgage payments in the event of a layoff or period of financial hardship.
Types of Home Equity Loans
Not all home equity loans are created equal. Each type of home equity loan has itsucture, fees, and restrictions. Even the same type of loan can vary widely depending on the lender and the terms that you negotiate and agree to.
The main types of home equity loans are:
- Home Refinancing
- Second Mortgages
- Home Equity Lines of Credit (HELOCs)
A refinancing loan is a large, lump-sum loan that you can use to help keep your mortgage payments on track. The maximum amount you can borrow for refinancing (from alternative lenders) is usually 80 percent of the home’s appraised value. Refinancing loans can carry fixed or variable interest rates, and since they effectively cover your existing mortgage, they may alter the interest rate on your mortgage. If you apply for a refinancing loan, you’ll be liable for administrative and legal fees on top of interest costs.
A second mortgage is a mortgage loan taken out against a property that is already mortgaged. Second mortgage lenders will generally let you borrow up to 80 percent of your home’s appraised value, minus outstanding debts. Interest rates for second mortgages can be fixed or variable, but are almost universally higher than the interest rates for the initial mortgage. As with refinancing, if you take out a second mortgage, you’ll also be liable for some legal and appraisal fees.
Home Equity Line of Credit (HELOC)
A HELOC is a revolving loan. Rather than a lump sum, you can withdraw or spend money as needed. Money that you pay back becomes available to you again.
With a HELOC, you can borrow 65 to 80 percent of your home’s appraised value, minus outstanding debts. The interest rates on HELOCs can vary with the market, but are generally lower than those for similar revolving loans like credit cards. Depending on the structure of your HELOC, you’ll also have to pay legal and administrative fees when you apply.
What Is the Process of Getting a Home Equity Loan?
As we talked about above, when you’re applying for a home equity loan it helps to know how much equity you have in your home. Records of your mortgage agreement and subsequent payments will tell part of the story, but to find out for certain it’s best to get your home appraised before you apply for a loan — especially if it’s been several years since you purchased it.
You can get your home appraised before you apply for a home equity loan, though many lenders charge appraisal fees to cover this process as part of your application.
To get a home equity loan from a bank, you’ll have to pass a “stress test”. A stress test is a government-regulated test that determines if you’d still be able to pay back your loan even under the “worst-case” economic scenario, with high interest rates. Your stress-test interest rate will be the highest of either the bank of Canada’s conventional five-year interest rate, or a rate you negotiate with your lender. If you don’t have mortgage loan insurance, then you’ll pick the higher of the bank of Canada’s rate, or the negotiated rate plus 2 percent.
Other lenders like credit unions, trusts, and alternative lenders are not required to use these stress tests, though they can if they choose to. If you borrow from an alternative lender, they’ll likely pay more attention to your equity than your financial history or credit rating.
Many people wonder how to pay off a home equity loan faster. The best way to pay off any loan faster is to ensure that you have enough money in savings, that you have steady income, and that you’re in good financial shape. A home equity loan is still a major loan which requires a commitment to regular, long-term payments. As with any home loan, if you default on payments, the lender can invoke foreclosure or power of sale.
Sometimes lenders can work with you to offer strategies — like additional monthly payment amounts — to help you put more toward your mortgage or home equity loan when you have the ability. Be careful, though — some home equity loans carry prepayment penalties, or financial penalties for making more than the allowed monthly payment.
A second mortgage or HELOC can also be used to pay off a mortgage faster, as they allow you to consolidate credit card and student loan debt with your mortgage loan and make one monthly payment. Whatever your goal, it’s always prudent to talk to your mortgage advisor or an experienced, reputable mortgage broker before applying for or agreeing to home equity loan terms.