Understanding Home Loans and Home Equity

Look at any bank’s website and you’ll find many options for home loans and home equity loans. Both allow you to borrow against the value of your home. Here’s what the terms mean and the differences between a home equity loan and home loan.

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Basically a home loan, commonly called a mortgage, comes as you are purchasing your home and helps you finance it. When you start making payments on that mortgage, you build equity in the home. That equity allows you to borrow more money through a home equity loan.

How A Mortgage Works

A mortgage is the primary way we finance private ownership of residential property. Most of us don’t have cash to pay for our homes so we finance it with a bank or similar lending institution.

Mortgages have an interest rate and amortize over a set period of time, typically 20-30 years.

You can find many books on mortgages/loan advice on Amazon: Mortgages and HELOC’s. Books are available for every topic and experience level so go ahead and browse a few titles.

Basic Parts Of A Mortgage

A mortgage is made up of many components but principal, interest, taxes and insurance are the major parts. Some lenders also require an escrow account for property taxes.

Here are brief descriptions of a home loan:

  • Property: the physical residence being financed.
  • Mortgage: the security interest of the lender in the property. This interest is secured by a lien.
  • Borrower: the person borrowing who is creating an ownership interest in the property.
  • Lender: Usually a bank or other financial institution.
  • Principal: the original dollar value of the loan.
  • Interest: a financial charge for using the lenders money.
  • Foreclosure: the possibility that the lender has to repossess the property. This is done by enforcing the lien that is created by the mortgage.
  • Closing costs, appraisals costs and points: fees that your bank adds to the loan.
  • Escrow account: monthly payment for property taxes and homeowner’s insurance.

How A Home Equity Loan Works

Home loans and home equity

A home equity loan is similar to the original home mortgage. You borrow a specific amount, and then you make payments during the repayment period. The key to a home equity loan is that your home needs to be worth more than what you owe on the original mortgage. There are also home equity lines of credit or HELOC’s.

If your home is worth $200,000, and you owe $100,000 on your first mortgage, you have $100,000 of equity in your home. Now you can use that equity as the collateral for a another loan. You can usually borrow up to 80 percent of your equity depending on your credit score and current debt like credit cards or car payments.

Home equity loans are often used to finance expenses such as home remodels, medical bills, or college education. A home equity loan creates another lien on the house and reduces your equity.

A home equity line of credit or HELOC is also a loan but you only use it when needed. It’s a little like a credit card, except your home is used as collateral. You don’t pay any interest or fees unless you have a balance and you can generally pay it off early with no penalties.

You can finance home improvements, consolidate credit cards or cover emergency expenses with a HELOC.

The main differences between a home equity loan and a home equity line of credit is that you get a lump sum of cash at an equity loan closing. You know exactly how much your monthly payments will be and how long it will take to pay off the loan. With a HELOC, you have access to your money and can use it when needed.

Research and Choose Which Loan Is Right For You

After signing a mountain of paperwork, you are now the owner of your own home or you took out an equity loan. Keep making those monthly payments. Remember if you fail to make payments on a mortgage or a home equity loan, the lender has the right to take ownership of the home.

Do the math and plenty of research in advance to determine how much house or maximum loan you can afford. Getting a loan can be a stressful and confusing process. So start early, ask friends and family for advice and shop around for the best rates.

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