Your home is not just an accommodation but a tool to help you make smart financial decisions. It is an asset that appreciates over time. Even if you have a mortgage on your home, its value increases with every down payment. It's the value that belongs to you and not the bank that is your home equity. You can use it to meet your immediate cash requirements, and home equity loans help you do exactly that.
What are home equity loans?
To understand equity loans, you must understand what equity is. Home equity is the difference between your home's current market value and what you owe on your mortgage.
Home equity mortgages or loans are secured against home equity. They are akin to a second mortgage since you are basically using your home as collateral for another loan. You can use these loans to renovate your house, pay for education, pay off another debt, or any other expense.
Types of home equity loans
There are two types of loans you can borrow against your equity:
Fixed-Rate equity home loans
Home Equity Line of Credit
Here's everything you need to know about these loans.
What is a fixed rate home equity loan?
A fixed-rate loan is ideal for you if you have big-ticket expenses that you need to pay in full at once. You get the entire amount from the lender in a single payment. You borrow money against your home's equity and repay the lender through regular payments covering both the principal amount and the interest.
As the name suggests, this type of equity loan has a fixed interest rate for the entirety of the loan period. Fixed home equity loans' interest rates are higher than normal home loans.
What is a home equity line of credit?
HELOC provides revolving credit like credit cards. You do not get a lump sum loan amount in a single payment. Instead, you get a line of credit that you can withdraw from whenever you need it. The lender decides the draw period (between 5 to 25 years) and loan amount based on your home equity. Then, you can withdraw a part of the approved loan amount whenever you need to cover different points in the draw period.
Unlike fixed-rate home equity loans, interest rates are variable. HELOC rates are based on the public index and calculated daily. As for repayment, you are only supposed to repay interest in the draw period. Once the draw period is over, you can start repaying the full amount in monthly payments.
It is best for you if you need funds for ongoing home improvement works and you need more time to repay your existing debt.
Comparison between fixed-rate loan and HELOC
Below is a comparison between the fixed-rate equity home loans and home equity line of credit
Fixed-Rate Loan
Home Equity Line of Credit
Interest Rate
Rates are fixed
HELOC rates are variable
Disbursement
Single lump sum payment
Revolving credit line
Repayment
Fixed monthly payments
Interest repayment during the draw period followed by full monthly payments
Lender Credit (discount points)
Lenders use discount points to lower interest rates
No discount points are used
Ideal Usage
When you have to make a big one-time payment
When you need funds for recurring expenses
Calculation of home equity loan amount
To understand the calculation of home equity loan amount, consider this example:
If you buy the house for Rs 40 Lakhs, with a home loan of Rs 30 Lakhs, your equity is Rs 10 Lakhs.
Note: If your current loan amount is zero, the equity home loan amount will be equal to the market value.
House equity fluctuates over time, which means it can improve or reduce depending on the real estate market in your area. Several factors lead to these fluctuations. So, you must get the calculation of home equity for a loan done by a professional real estate appraiser.
Consider this example,
After five years, your Rs. 40 lakhs property is worth Rs. 50 lakhs. At the same time, you have repaid Rs. 10 lakhs of the loan amount. Then, your equity will be:
Rs. 50,00,000 – Rs. 20,00,000 = Rs 30,00,000
Now, you can take an equity loan of up to Rs. 30 lakhs
Eligibility criteria for home equity loans
Here's a general checklist of factors that affect your eligibility:
Equity: The value of your house equity should be more than 20% of the market value of your house.
Income: You must have a verifiable income history for at least the past two years.
Credit Score: Like every other loan, a low credit score can reduce your chances of getting a loan. Make sure you have a credit score of 620 or more.
Debt: Make sure your debt/income ratio is less than 43%.
LTV: The loan to value ratio shows how much you still owe on your current home loan. Ideally, it should be less than 80%.
CLTV: Lenders use a combined loan to value ratio if you apply for HELOC. You can calculate CLTV by adding the loan required with your current loan balance and dividing the sum by your house value. Most lenders require a CLTV of 85% or less for you to be eligible.
How to improve home equity?
Although house equity fluctuates over time depending on the local real estate market, you can still take steps at a personal level to build your equity. Here's how:
Pay off your mortgage quickly: Focus on repaying your loan faster. You can choose a shorter term, make bi-weekly payments, and use bonuses and tax returns to repay the mortgage faster. The more you pay, and the quicker you pay it, the more equity you will build in less time.
Pay big down payment: The down payment you make for the home loan adds to the equity. You can pay a maximum of 20% of the loan amount as a down payment.
Add value to your house: You can renovate your house, upgrade the kitchen, and add rooms to increase your house's market value, resulting in higher equity.
Wrapping Up
Home equity loans allow you to use the potential of home equity that otherwise would remain idle and take advantage of the market value of your house to fulfill your immediate financial needs.
If you are looking to purchase a house for yourself, check out Tata Capital's easy home loans tailored to help you get your dream house hassle-free. Visit our website to learn more.
28 June 2022
6 mins read
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