What is an equity loan?
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UPDATED: Feb 9, 2021
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An equity loan—which is also known as a home equity line of credit (HELOC)—is a form of revolving credit in which a home serves as collateral. Since a home is usually a consumer’s most valuable asset, HELOC’s are often used for major purchases or financing opportunities, such as education, home improvements, and medical bills. Naturally, these are not for day-to-day expenses.
If given a home equity loan, borrowers will be approved for a specific amount of credit. Most lenders set credit limits on a home equity line by taking into account a number of factors:
- The current appraised value of a property
- The amount applicants still owe on their property
- The ability of borrowers to repay
Credit limits are then determined by taking a percentage of the appraised value —usually around 75 percent—and subtracting from that total the outstanding balance owed on the property
As with nearly all forms of lending, HELOC lenders will determine the actual credit limit by considering the ability of a prospective borrower to repay. This includes an examination of a prospective borrower’s income, current level of debt, financial obligations, and credit history.
The Rules of Withdrawal
Most equity loans are on a set fixed period (such as a 10 year period) during which borrowers are allowed to borrow money. Once this “draw period” (the period in which a borrower is permitted to withdraw money from the equity line) finishes, borrowers may be permitted to renew their line of credit. Most plans will require payment in full on any outstanding balance at the conclusion of the “draw period.” However, some lenders may allow flexible repayments to be made over a fixed period (such as a 10 year period). These are called repayment periods.
If a HELOC borrower is approved for an equity loan, the borrower will likely be able to borrow up to the credit limit whenever the borrower wishes. In order to withdraw from their credit line, HELOC borrowers are typically required to use special checks. HELOC borrowers may also access their credit line via a special credit card.
There are some risks that come with borrowing equity loans though. If borrowers default, their home could be foreclosed upon since their home is the underlying collateral. Naturally, HELOC borrowers should take into account their own ability to repay their equity loan and avoid the possibility of default. Additionally, if the value of the home decreases then the lender may freeze or adjust the amount of money available in the credit line.
HELOC borrowers with equity loans may be required to adhere to certain requirements on the use of their credit. Some lenders require borrowers to withdraw a minimum amount each time the credit line is accessed (such as a $300 minimum). Borrowers may also be required to keep a minimum outstanding amount.
Additionally, some plans may require that borrowers withdraw an initial advance once the credit line is created.