Home Equity Loans - Q&A

Using your home equity

What is "equity"?

Equity is the difference between the value of your home and the outstanding balance of all mortgage loans secured by your home, including any home improvements loans, other home equity loans or lines of credit. If, for example, the value of your home is $100,000 and the balance on all existing mortgages liens is $60,000, your equity is $40,000.

What is a "home equity loan"?

A home equity loan is a mortgage loan secured by a lien on your property that's purpose is to provide you with cash at closing to be used as you see fit. A home equity loan can be a second "subordinate" loan obtained in addition to an existing mortgage for purpose of providing cash to the borrower or it can be a new primary mortgage with a loan amount sufficient to pay off the existing mortgage and provide the borrower with additional cash at closing.

Can I borrow the full amount of my equity?

As with any mortgage loan lenders are hesitant to lend up to the full value of the property securing a mortgage loan. This is because if the borrower defaults on the mortgage and the mortgage lien is "foreclosed", the property will not likely bring its full market value at the foreclosure sale. If, for example, a home is secured by a first lien of $80,000, and a subordinate home equity loan of $20,000, a default on the first lien that led to foreclosure would likely extinguish the second lien entirely. Notwithstanding these risks, some lenders will lend up to 100% of the value of a borrower's primary residence because the likelihood of a default and foreclosure on the property in which the borrower resides is much less than with a second home or investment property. However, in some states, such as Texas, the law provides that a lien securing a "home equity" on the borrower's "homestead" (typically the borrower's primary residence) is invalid if it exceeds 80% of the home's value. Thus, in our example where a home is valued at $100,000, and there is an existing lien of $60,000, the lender will lend no more than $20,000 on the subordinate lien because of the practical and legal limitations.

Is a "home equity loan" always a subordinate second lien?

No. If, for example, there were no existing mortgage loans secured by the property (i.e. the property had originally been purchased with cash or the prior mortgage loans had previously been paid in full) the borrower could obtain a home equity loan in a first lien position. Also, the proceeds of a home equity loan might be used to pay the balance on all existing liens and to additionally provide the borrower with cash for other purposes. This loan is still a home equity loan and will typically be subject to all of the legal limitations existing for a home equity loan in a second lien position. However, because loans in a first lien position are less risk than subordinate second liens, the rate on a first lien home equity loan will usually be more favorable than the rate on a second lien home equity loan. This is true of other types of loans as well. The second lien mortgage loans carry a higher risk of default and loss and thus will typically have a higher interest rate than a comparable first lien mortgage. This is true even where the second lien proceeds were used to purchase the property.

What is the difference between a standard refinance and a home equity loan?

A refinance transaction in which the proceeds are used to pay existing valid liens, plus accrued interest on those loans and the typical costs associated with completing the refinance transaction (i.e. where the borrower does not receive cash for other purposes) is referred to as a "rate and term" refinance and is not considered a home equity loan. Please note that in the state of Texas, a loan whose proceeds are used to pay any portion of a prior home equity loan is "deemed" to be a home equity loan to which all the legal limitations that exist for a standard home equity loans (one in which cash proceeds are paid to the borrower) apply. However, for the purpose of qualification and pricing (rate and costs) the lender may consider this type of loan (where the borrower receives no cash) to be more similar to a standard refinance and therefore the qualification standards and pricing may be no different than with a standard rate and term refinance even though the state's legal limitations will apply.

Is a loan for the purpose of home improvements considered a home equity loan?

If the borrower receives cash in a refinance transaction and has the choice of using the proceeds to pay for home improvements or other purposes the loan will be considered a home equity loan. If, however, the legal requirements are met to establish a "contractor's" or "mechanic's" lien at the time of a home improvement loan and the proceeds are used solely to pay the cost of materials and labor for home improvements the resulting transaction is not a "home equity" loan. This loan and any loan that "renews and extends" this type of loan in a later refinance transaction is not required to meet the state legal requirements for a "home equity loan". However, a loan that is not considered by state law to be a "home equity loan" may be deemed by the lender to be more similar in risk to a "cash-out" loan and for that reason may be more strictly viewed for qualification purposes and may carry a higher rate or pricing adjustment (more points at the same rate). The most common example is a refinance transaction where the proceeds are used to pay the balance on an existing home improvement loan. As previously noted, if the legal requirements of the state for establishing a contractor's lien ("mechanic's lien") were met at the time the home improvement loan was made this lien will be considered a valid existing lien the refinance of which is not considered "home equity loan" with regard to state legal limitations or requirements. The restriction in Texas prohibiting a valid "home equity" lien where the loan amount of the property loan plus the balance of any other liens secured by the property exceeds 80% of the value of the property does not exist on a "home improvement" loan provided the legal formalities related to this type of loan have been met. Thus structuring a loan where the proceeds are intended to be used for home improvements will permit the loan to value ratio (LTV) for that loan to be as high as 95%.

If I pay only credit card or other bills at the closing and receive no cash is the loan still considered a "home equity loan"?

Yes. Even though you received no cash at closing the proceeds of the loan were used to pay debts that were not secured by existing valid liens on the property. This is true even where the payment of the loans was required as a condition to making the loan.

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