What Is a Closed-End Home Equity Loan?

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DEFINITION

A closed-end home equity loan lets a homeowner borrow against home equity, or the difference between a home’s market value and mortgage balance. With a closed-end loan, a borrower typically gets a lump sum. That money plus interest must be repaid by a specific date.

Definition and Examples of a Closed-End Home Equity Loan

A closed-end home equity loan is similar to a traditional home mortgage. Both loan types allow you to borrow a set amount, which you repay through monthly principal and interest payments. Both loan types use your home as collateral. While a traditional mortgage gives you the money to buy a home, a closed-end home equity loan allows you to tap into your home's equity.

Homeowners could take out a closed-end home equity loan for purposes such as:

  • Consolidating debt
  • Paying for home improvements
  • Buying a car
  • Debt consolidation
  • Covering a child’s college expenses

In most cases, a closed-end home equity loan must be repaid within five to 30 years. Once money has been repaid, it can’t be re-borrowed (as with a HELOC). Some financial institutions’ closed-end home equity loans have fixed interest rates that never change, but adjustable-rate and variable-rate closed-end home equity loans do exist.

  • Alternate names: second mortgage, home equity loan

Your ability to take out a home equity loan depends on your outstanding mortgage balance, the appraised value of your home, your home equity amount, and factors such as your credit score, income, and credit history.

If you owe $200,000 to your mortgage lender and your home’s value is $350,000, your equity totals $150,000. A lender then comes up with the loan-to-value ratio (LTV) and combined loan-to-value ratio (CLTV) to determine your loan eligibility and how much money you can borrow. Loan-to-value ratio (LTV) compares your primary mortgage against your home’s current appraised value. The combined loan-to-value ratio (CLTV) includes all loans backed by your home, such as a primary mortgage and a home equity loan.

How Does a Closed-End Home Equity Loan Work?

When you take out a closed-end home equity loan, you typically receive a lump-sum amount, such as $50,000. You then repay the loan of $50,000 plus interest with fixed monthly payments over a certain period of time (such as 20 years).

Here’s an example of the calculations a lender does to determine whether you might qualify for a home equity loan. First, the lender sends out an appraiser to determine your home’s appraised value. Then, the lender performs some calculations:

Home’s appraised value - Mortgage balance = Home equity

350,000 - 200,000 = 150,000

You have $150,000 of equity in your home to borrow against. A lender then calculates your loan-to-value ratio to see how much you still owe on your original mortgage:

Mortgage balance / Appraised value = Loan-to-value ratio

200,000 / 350,000 = .57

Converting that number to a percentage (by multiplying it by 100) gives you 57%.

A lender then calculates the combined loan-to-value ratio (CLTV) to see how your new home equity loan will impact you:

(Current mortgage + desired home equity loan amount) / Appraised value = Combined loan-to-value ratio

(200,000 + 50,000) / 350,000 = .71

Converting that to a percentage, you wind up with 71%. Some lenders let you borrow as much as 90% to 100% of your CLTV, but a typical lender limits that number to 80% to 85%.

Alternatives to a Closed-End Home Equity Loan

A closed-end home equity loan isn’t necessarily right for everyone. Here are some alternatives.

Home Equity Line of Credit (HELOC)

A HELOC allows you to tap into your home’s equity. But instead of borrowing a lump sum of money as you would with a home equity loan, a lender approves you for a line of credit based on the amount of equity. Much like a credit card, a HELOC enables you to borrow up to your credit limit over time and eventually pay off what you’ve borrowed.

Cash-Out Refinance Loan

This type of loan pays off your original mortgage and replaces it with a new mortgage. After the original loan is paid off and various closing costs are covered, you can spend the remaining lump sum of cash any way you’d like.

Personal Loan

If you don’t want to use your home as collateral (as you must with a home equity loan), HELOC, or cash-out refinance loan, you might explore an unsecured personal loan. Money borrowed through a personal loan comes in a lump sum. An unsecured loan may charge higher interest rates than a home equity loan.

Credit Card

Similar to a HELOC, a credit card gives you access to a line of credit. While a credit card doesn’t require you to use your home as collateral, it typically charges higher interest rates than a home equity loan.

Pros and Cons of a Closed-End Home Equity Loan

Pros
  • Access to a lump sum of cash

  • Fixed or adjustable interest rate

  • Potential tax deductions

Cons
  • Risk of foreclosure

  • Closing costs

  • Higher interest rate and closing costs than HELOC

Pros Explained

  • Access to lump sum of cash: A home equity loan provides a lump sum of cash right away to cover major expenses.
  • Fixed or adjustable interest rate: Most HELOCs offer a variable interest rate, but a closed-end mortgage may offer a variable or fixed rate. A fixed rate stays the same over the loan’s lifetime—potentially good if rates are low.
  • Potential tax deductions: Interest paid on a home equity loan for substantial home improvements may qualify for a federal tax deduction.

Cons Explained

  • Risk of foreclosure: If you fail to make timely payments or make payments at all, you risk the lender foreclosing on your home.
  • Closing costs: The appraisal, various fees and other closing costs can add up to roughly 2% to 5% of the loan amount.
  • Higher interest rate and closing costs than HELOC: Although home equity loan interest rates are generally lower than for personal loans and credit cards, rates are usually higher than the interest rates for HELOCs, and closing costs can be higher, too.

Key Takeaways

  • A closed-end home equity loan lets a homeowner take advantage of a home’s equity to borrow money for debt consolidation, home improvements, and other significant expenses.
  • Many lenders allow homeowners to borrow up to 80% of a home’s equity.
  • To qualify for a closed-end home equity loan, the borrower will have a home appraised.
  • A closed-end home equity loan is often paid with fixed monthly payments, within five to 20 years.

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