A home equity mortgage is a real estate loan that enables homeowners to borrow against the equity in their property. Equity is the positive difference between what is owed on a property and what the property is currently worth. For example, if a home owner owes the bank $100,000 US Dollars (USD) on a property that is currently worth $150,000 USD, the owner has $50,000 USD of equity in the home. Therefore a home owner with $50,000 USD equity in their home may be able to obtain a home equity mortgage loan of up to $50,000 USD from a lender.
There are two primary home equity mortgage loans that borrowers can choose from. The first is a home equity line of credit (HELOC) and the second is a fixed loan. When a borrower obtains a home equity mortgage, the original loan is not replaced by a new loan as it is with a refinance. While the HELOC and fixed second are structured differently, both are second mortgages that are subordinate to the first mortgage on the property. If a borrower defaults and the home is foreclosed and sold, the proceeds from the sale go first to the lender of the first mortgage, with any remaining proceeds going to the lender of the second mortgage. The additional risk of a second mortgage for the lender is one reason why interest rates are often higher for home equity mortgage loans.
A HELOC is a line of credit that operates very similarly to a credit card. The borrower opens an account with a credit maximum that he can borrow from over a set period of time. During the period of time known as the "draw period," the borrower is able to draw, or access, some or all of the credit line through the use of checks or a debit card. After the draw period is the repayment period, during which the borrower is no longer able to access the credit line and must repay the amount outstanding by the end of the repayment period.
Like a credit card, the borrower is responsible for paying interest on whatever portion of the credit line is currently drawn. A HELOC is a simple interest loan, meaning that the lender multiplies the amount outstanding by the interest rate, which is generally a variable rate that can fluctuate over the life of the loan, to calculate the minimum payment due.
If a borrower draws $10,000 USD from a $50,000 USD HELOC with a current interest rate of 6%, the borrower would be responsible, during the draw period, for paying only the interest on the $10,000 USD, or $600.00 USD per month. If a borrower pays the full amount outstanding, there would be no minimum payment due until another draw is made. Once the draw period ends and the repayment period begins, the calculation for the minimum payment typically changes depending on the terms of the loan.
In contrast to a HELOC, a fixed home equity mortgage loan is not a revolving credit line but rather a fully amortized loan with set monthly payments based on an amortization schedule. Each payment made goes toward the principal, or original amount borrowed, of the loan and to the interest charged by the bank. If a borrower pays more than the minimum each month, or pays off the loan balance early, he would not be able to access any of the funds pre-paid, as he would be able to with a HELOC.
