How Home Equity Line of Credit Mortgages Work

For many people, their home is the most expensive thing they own and also the largest concentration of wealth that they have. In addition, home values are at least somewhat predictable and unlike cars, homes do not drive away. These characteristics make homes very attractive collateral for loans. When a home owner owes less in debt on a home than the home is worth, the difference between those two numbers is the home owner’s equity in the house. That equity, combined with the attractiveness of a home for collateral, gives the owner an opportunity to take out home equity credit in the house.

At its heart, a home equity line of credit is a variation on an additional mortgage on the house. Calling a home loan a mortgage is actually inaccurate. The mortgage is the piece of paper that tells a bank that it is entitled to take possession of a home and sell it if the borrower stops paying the loan. In most traditional home borrowing situations, homes have one loan against the value of the house and one mortgage to the lender who made that loan. But additional lenders can loan money in exchange for the right to get in line behind the main lender in case of default.

There are various ways that a bank might allow a home owner to borrow against the equity in the home. In some cases, the lender might make a single disbursement of cash in exchange for a promise to repay. In other cases the lender might open up a line of credit up to a certain limit, and the home owner can use as much of that credit as he or she needs. Regardless of how the credit is extended, there are certain steps that banks will require first.

The two most important steps for the bank will be to evaluate the value of the house and the total amount owed. No bank wants to find itself last in line to recover money from a house that is worth less than the total amount owed. Expect that any bank that is thinking of extending a home equity loan to insist on a home appraisal. The appraiser will give an estimate of the market value of the home based on recent comparable sales and the state of the real estate market as a whole. The bank will then compare the value of the home to the total amount already owed to other banks to see how much equity there is. Of course, as with all other credit situations, expect that the bank will also want to review the homeowners’ credit history to ensure that they are not a major risk for default.

After assuring itself that the loan will not be more than the homeowner can pay, and that the house will still be worth more than the total debt linked to the home, the bank will be ready to sign the loan note, the mortgage, and certain mandatory forms for reporting to the state that there is a new mortgage on the home. The process for closing the home equity loan will be similar to the original home closing except for the involvement of the sellers. At the end of the process, the homeowner either walks out with cash in hand or a method of tapping into that equity in the future, either through checks, transfer instructions, or other ways to get to the funds.

During times of increasing home values and rising income, taking out home equity credit is a way to tap into the large store of wealth that a home represents for most home owners. The bank will look carefully to avoid holding a loan on an upside-down property, but once the formalities are taken care of the home provides solid collateral for home improvement, debt consolidation, of any of a number of other uses for that cash.