Mortgages provide collateral for many loans, giving lenders a guarantee in cases when borrowers cannot make the required monthly payments. Considering that mortgage loans are based on the property’s worth, is a home equity loan a mortgage?
Yes, a home equity loan is a mortgage, as the loan is primarily secured through the owner’s equity in the property. The loan is made of a single lump-sum payment representing a difference between the home’s market value and current debt balance, allowing the borrower to access more funds quickly.
A home equity loan is typically taken out as a second mortgage. If your financial position allows it and you qualify for the loan, you will have the opportunity to refinance the existing debt with much lower interest rates.
Yes, Home Equity Loan is a Mortgage
A home equity loan is a mortgage that you can take out against your home’s equity, which is the percentage of the property you own outright. These loans are typically used as a second mortgage, so the equity is calculated as the difference between the property’s appraised value and the existing loan’s balance.
If approved, you will receive a new line of credit that goes up to the value of your equity, with the money being issued as a one-time lump sum payment. Like traditional mortgages, these loans are repaid in monthly installments over a fixed period of 15 to 30 years, often with a fixed interest rate.
They also have lower closing costs, making them an excellent pick for borrowers whose new financial situation allows them to refinance and pay off their original debt faster.
Lenders issuing home equity loans as a second mortgage are at greater risk of foreclosure, as they don’t get a return for their money until the first one is paid off. This is why they typically come with much higher interest rates compared to traditional mortgages.
How Is the Amount of Credit Calculated When Taking Out a Home Equity Loan?
To determine the amount of money you can borrow when taking out a home equity loan, a lender will use the loan-to-value (LTV) ratio. This formula helps them calculate how much equity is left in the home after your first loan has been paid off by dividing the remaining mortgage balance by your home’s current appraised value.
For starters, we know that the maximum amount a lender borrows in a typical mortgage is 80% of the home’s value. For example, if the house you put as collateral was appraised for $250,000, you can borrow up to $200,000.
Considering there’s still 20% of the property value left, you will own $50,000 in equity, which will only grow as you make the monthly payments. This means you will have bigger collateral for your new debt the more you pay off the initial mortgage.
If you are thinking about taking out a home equity loan, take a look at how much money you can get with a loan-to-value (LTV) ratio of 60%.
|Appraised Home Value||Initial Mortgage Balance (80%)||Remaining mortgage balance||Loan-to-Value Ratio||Borrower’s Equity||Maximum Collateral for a Home Equity Loan|
|$250,000||$200,000||$150,000||60%||$100,000||$80,000 – $85,000|
Most lenders require a 75-80% loan-to-value (LTV) ratio or lower to minimize their foreclosure risks, meaning you will have to own at least 20-25% of the property. If you are already under a mortgage, you will have a tough time getting approved for a home equity loan without making any payments to the original lender.
On the other hand, having a low loan-to-value (LTC) ratio or paying off and discharging your mortgage will give you a distinct advantage over borrowers who don’t have a credit history or haven’t completely paid off their first-position debt.
Can a Home Equity Loan Be a First Mortgage?
While a home equity loan is typically used to refinance debt, it can also be used as a first mortgage or after you pay off the previous one. You will still need to qualify for the loan, so make sure you fulfill all the requirements before applying.
What Are the Requirements for Taking Out Home Equity Loans?
While the requirements to qualify for home equity loans vary between lenders, they are very similar to assuming a mortgage. The list of requirements typically includes:
- Home equity – at least 20%,
- Credit score – 620 or better,
- Debt-to-income ratio – 43 or lower.
To properly assess how much you are eligible to borrow, the lender will also require an appraisal of your home’s current market value. They will also need recent income verification, retirement benefits, and tax returns.
Is a Home Equity Loan Tax Deductible?
Home equity loans are tax-deductible, but only if the money is spent on home improvements for the property that was put forward as collateral. This was decided in accordance with the Tax Cuts and Jobs Act of 2017, which suspended all deductions on interest from 2018 to 2025.
Before the Act, borrowers had the option to deduct any expenses made with these loans, including paying off debts with high-interest rates. The Act also added a new deduction limit for all residential debt, lowering it from $1 million to $750,000.
Should I Get a Home Equity Loan?
The answer to whether you should take out a home equity loan will mostly depend on your current financial situation and the reason behind your application. If you are already under a loan with a higher interest rate, this could be a great way to refinance. It’s also an excellent choice for renovations, as these expenses can still be tax-deductible.
However, make sure you can afford a mortgage first, especially if you are already under one. Missing or being late on even a single payment will put you at risk of losing the property altogether.