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How Are Home Equity Loan Rates Calculated
Home equity loans, also known as second charge mortgages, are a powerful way for homeowners to make use of their greatest asset - their home. With a home equity loan, property owners can access large levels of finance to help them in other aspects of their lives, whether it’s for further investment in their property, to clear out and consolidate other debts, or to help a family member get their own foothold on the property ladder.
At Clifton Private Finance we help homeowners access superior funding, with low home equity loan rates and flexible terms, but how do we do that? To understand how home equity loan rates are calculated, we dig into the mind-set of the lenders and look at how they assess risk.
Table of Contents
- Home Equity Loans vs. Remortgaging
- The Lender’s Perspective on Rates
- How Collateral Lowers Risk (and Rates)
- Additional Factors Determining Rates
- How Interest is Charged
- Getting the Best Home Equity Loan Rates
Home Equity Loans - Secondary Debt Secured by Your Property
A home equity loan is a type of secured loan that is guaranteed by your home as collateral. It is considered secondary debt, which means that it is of less seniority to the primary debt of your main mortgage.
A home equity loan is not a remortgage - a remortgage is the act of refinancing your main mortgage. Instead, a home equity loan is an additional finance product that sits alongside your mortgage.
If the property is repossessed and sold on, the mortgage takes priority and is paid first, with the secondary home equity loan only paid once the mortgage is fully cleared. This makes the home equity loan a greater risk than a main mortgage and is one of the reasons that the home equity loan interest rate is higher than your mortgage rate.
However, this type of secondary debt is not without its advantages. Because the home equity loan is separate to the mortgage, it doesn’t need you to go through a lengthy and complicated remortgaging process. Instead it can be applied for relatively simply, assessed quickly, and obtained in a far shorter time frame. It also has its own term length and is typically shorter than your main mortgage, meaning it will be paid off sooner and accrue less interest over time.
Home Equity Loan Case Studies
The Lender’s Perspective - Understanding Home Equity Loan Rates
Lenders are businesses providing a service. They are there to make a profit and they do so by charging interest on the money they loan out. Looked at simply, if a lender can charge more, they will. However, the loan business is competitive, so lenders need to balance the amount they charge by the demand for their service and how much other lenders are charging.
Consider the following from the lender’s perspective:
- If a customer is low risk, everyone will be happy to lend to them.
- Conversely, if a customer is high risk, fewer lenders will lend to them.
- If many lenders will lend to the customer (low risk), then the rate needs to be low to be competitive.
- If few lenders will lend to the customer (high risk), then the rate can be higher and still be competitive.
From this key understanding, it’s easy to see how risk is the greatest concern for a lender. If you, as the customer, present a high risk then you are going to find fewer lenders willing to lend to you, and with fewer options, the loan rates will be higher. If you are a low risk customer, you have far more options choosing which lender you will go for, leading to a competitive marketplace that offers better rates.
Home Equity Loans - Lowering Risk Through Collateral
The key consideration that makes a home equity loan less risky for the lender than many other types of finance arrangement, is that you are providing your property as an asset that can be used as collateral on the loan.
This means that if you fail to make the repayments as agreed, the lender can repossess and sell on your home to recoup their losses. It is a significant security for the lender and lowers your risk profile considerably.
- This is why home equity loans have far better rates than other loans you might see, such as unsecured personal loans or credit cards.
- You are moving some of the risk from the lender to yourself through the act of providing your home as collateral. Of course, by doing so, you make the loan more risky to you. For this reason, home equity loans need to be thought about carefully for a fully informed decision.
- Are you confident that you can make the repayments each month?
- Have you considered all your other financial responsibilities to make sure you have sufficient income to comfortably cover the loan?
- Have you looked at the length of the loan and understood that you must keep making repayments for the entire term?
- Have you taken the time to read and understand the terms and conditions of the loan, to understand the potential fees should you want to repay early?
- Are you fully aware that a failure to make repayments may result in the loss of your home?
Low home equity loan rates are a huge benefit, but only if you are in the position where you are confident and comfortable with the loan terms. It is worth discussing the loan terms and your financial position with a professional home equity loan broker.
Additional Risk Factors - How Lenders Determine Home Equity Loan Rates
All home equity loans are based on the use of your home as security for the loan - that’s a constant. So what are the other factors that go in to the lender’s rate calculation?
Loan to Value (LTV)
Loan to value (LTV) is the size of your loan (the amount you borrow) when compared to the equity you have in your home.
Your equity in your home is the amount of the home you own in full - that is to say, the amount not currently owed on your existing mortgage. For example, if your home is worth £350,000 and your outstanding mortgage balance is £225,000, then you have equity of £125,000 (£350,000 - £225,000).
- If you borrow £60,000 in that situation, the LTV is 48%.
- A 50% LTV loan would be £62,500 (half of the equity).
- An 80% LTV loan would equal £100,000.
The maximum available to borrow is typically a total of 85% of the total property value combined across all debt. In the example above, this would be 85% of £350,000, or £297,500. With the primary mortgage representing £225,000, a home equity loan of £72,500 would be available.
The lower the LTV, the lower the risk for the lender as they are more likely to get their money back if the house has to be sold to cover the debt.
Credit Rating
As with all finance arrangements, your credit history has a significant part to play in getting superior rates. Compiled by assessing your financial dealings, your credit rating is a trusted mechanism for banks and other lenders to gain a picture of your financial responsibility.
It is always worth working on improving your credit score before looking to obtain a loan.
Length of Loan Term
The length of your loan can affect your loan rate.
Shorter loan terms often come with lower interest rates because they pose less risk to lenders, though this isn't always the case - longer-term loans can sometimes offer competitive rates because they generate more interest over time.
When choosing between short and long terms, it is worth considering both the size of the monthly repayment and the total interest paid over the entire loan lifetime.
Fixed vs. Variable Rates
Choosing between a fixed-rate term and a variable one will have an impact on the loan interest rate. Fixed-rate terms represent a known quantity with the repayment being the same each month, making them easier to manage and predict. Variable rates are safer for the lender as they move the risk of changing markets from the lender to you, however, though they are lower at the start of the term, by their nature, they may well be higher by the end of the period.
The length of homeowner loans means that you may refinance the loan part-way through the term, moving from fixed rates to variable and vice versa. Thus, a decision at the beginning of your agreement is rarely set in stone for the whole life of the loan.
Economic Market Conditions
Interest rates in the UK fluctuate based on the Bank of England base rate, itself heavily influenced by inflation and geo-political concerns. In real terms, this means that you may find a better rate is offered tomorrow than the one available today. Predicting the market conditions effectively is complicated and difficult - for most people the realistic option is to consider the market as it stands and not put off getting a loan for weeks or longer in the hope that something changes.
However, your loan broker may have a greater understanding of the wider market conditions that will help you when it comes to timing your loan application to obtain the best rate. When you are close to finalising your application, discussing the greater UK loan market with us at Clifton Private Finance may help you save on your home equity loan.
How Interest is Charged
Like a standard mortgage, your home equity loan will be structured with a monthly payment that is made up of both a capital repayment and an interest payment. That interest is calculated each day based on the current balance, and added monthly onto the loan.
As time goes on and the balance lowered, the amount of interest generated will be smaller and a greater portion of your monthly repayment will go towards repaying the capital.
The total interest you repay will be dependant on the home equity loan interest rate and the length of the term. Overall, a longer term will result in more interest paid than a shorter one.
Getting the Best Home Equity Loan Rates with Clifton Private Finance
Clifton Private Finance is a premium finance broker with expertise in the home equity market. We work with the full range of UK lenders, from high-street banks to specialist home equity lenders, to provide our customers with the best home equity loan deals available today.
We work as your partner to ensure you get the best rate possible. By fully considering the key factors that form the lender’s risk assessment and decision-making process, we optimise your chances and save you thousands of pounds over the course of your home equity loan term.
Unlock the financial power held in your home equity by speaking to a Clifton Private Finance advisor today.
To see what we can do for you, call us on 0117 313 5980 or book a free consultation below.
