What is an equity loan? (Let’s end the confusion)
Equity loans can cause a few headaches, not because they’re a problem (in fact, they can be very useful), but because of the common confusion in how they work.
Remember, ‘equity loans’ and ‘home equity loans’ are two different things.
Equity loans and home equity loans: what’s the difference?
You might be looking for an ‘equity loan’, where you’d be making additional borrowing as a top-up to the amount you’re able to borrow through your main mortgage provider. Or, you might be interested in a ‘home equity loan’, which is a form of credit, using your equity as collateral. Cut through the jargon and get to grips with how these different equity loans work, starting with a clear definition and example.
What is an equity loan?
Equity loans: a quick definition
An equity loan is the term used to describe additional borrowing, which acts as a top-up to the amount you’re able to borrow from your bank, lender or main mortgage provider. The government’s Help to Buy loan is a good example of an equity loan (and we’ve covered this in more detail below), designed to help buyers who wouldn’t otherwise be able to fund their purchase. Equity loans are also widely used by building companies, to encourage house sales.
Equity loans: an example
Property price: £220,000
A 20% equity loan arrangement on this property would work out as follows:
Your deposit: £11,000 (5%) + Bank/lender mortgage: £165,000 (75%) + Equity loan: £44,000 (20%)
Total sale = £220,000 (deposit, mortgage and equity loan combined)
When talking of equity loans, it is normally assumed these are loans that share in the equity of the property (as opposed to second charge mortgages which do not). What this means is that the amount you have to repay increases or decreases depending on the value of the property - we’ll look at an example in the Help to Buy section below.
What is a home equity loan?
Home equity loans: a quick definition
A home equity loan (also known as a ‘homeowner loan’) is essentially a form of credit. It allows you to borrow money, using the equity from your home (the portion you yourself have paid for) as collateral (security which you’ll lose, if you default on the loan terms or repayment). How much you can get as a home equity loan depends on the value of the property, and this will be decided by the lender.
Home equity loans are often used to fund big financial outgoings, such as a renovation job, repair work or even medical treatment. They can be useful credit lines for people with no mortgage left to pay (or very little), who have an excellent credit rating, and need to raise cash without selling their home.
Home equity loans: an example
Appraised value of your home: £300,000
Your outstanding mortgage balance: £70,000
In this case, the value of your home minus your outstanding mortgage balance is £230,000, giving you a potential loan value of £230,000. You don’t need to take the full amount as a loan of course, it depends on what you’re looking to finance.
Remember, this loan would be taken using your £230,000 as collateral. If your loan repayments defaulted, your money would be at risk. You need to think very carefully before using your home to secure debts, as ultimately, it could result in repossession.
What is the Help to Buy: Equity Loan?
Help to buy is a government initiative, set up to help people move home with a low deposit (down to 5%). There are actually two schemes – Help to Buy: Shared Ownership and Help to Buy: Equity Loan. We’ll focus for now on the Help to Buy: Equity Loan, which works very much like to equity loans we’ve covered above.
How does it work?
The Help to Buy: Equity Loan is designed to help people buy their own home, when working with a low deposit. With this loan, the government will lend you up to 20% (40% in London) of the cost of the home you want to buy. It will need to be a new-build, priced up to £600,000 and you’ll only need a 5% cash deposit and 75% mortgage. The government will essentially make up the rest, as a loan.
This equity loan is open to first time buyers or people looking to move home, but this must be the only property you own.
Fees (and paying off the Help to Buy: Equity Loan)
You won’t be charged fees on this loan for the first five years that you own your home. After that the interest rate starts at 1.75% and increases in line with inflation plus 1%.
You’ll have to repay the loan when you sell the property (or after 25 years). The amount you have to repay depends on the value of the property. For example if the value of the property we considered above increases from £220,000 to £250,000, your 20% equity loan will need to be paid back at £50,000 instead of the £44,000 that you borrowed. For more information on the fees involved and repayment procedure, take a look through the government’s Help to Buy Buyers’ Guide.
London Help to Buy
Average home prices in London tend to be higher, so Help to Buy shifts a bit if you’re looking to buy in the capital. The upper limit that you can borrow is 40%.
Mortgage refinancing (an alternative to home equity loans)
Any loan involving your property as collateral needs to be thought through very carefully. Knowing all your options is crucial, and in the case of home equity loans, mortgage refinancing might be an alternative worth exploring.
With mortgage refinancing, usually you’d be looking to increase your mortgage, in order to take out some (or all) of the extra cash. Lenders will approach this differently, and depending on your circumstances, so if it sounds interesting, check in with yours and ask for your options.