A General Guide to Home Equity Loans

A home equity loan is a loan that is available to homeowners. In the most basic sense a loan is a sum of money that is borrowed by a person or company and then repaid, with interest (a percentage of the loan amount, usually calculated on an annual basis), over a set period of time. Two principal parties are involved in loan transactions: a borrower (the party borrowing the money) and a lender (the party lending the money).

The two basic types of loans are secured and unsecured. In obtaining a secured loan the borrower presents the lender with some piece of property (for example, an automobile), of which the lender can claim ownership in the event the borrower fails to repay the loan (also known as defaulting on a loan). This property is known as collateral. Unsecured loans, on the other hand, do not require the borrower to have collateral. A home equity loan is a form of secured loan, in that the borrower uses his or her house as collateral to secure the loan. People take out home equity loans for various purposes, such as undertaking home improvements or paying off debt (something-for example, money, a piece of property, or a service-that an individual owes to another individual or an entity).

In almost all cases a home equity loan will represent the second loan a borrower secures using his or her house as collateral. Because houses are very expensive, most homebuyers must first take out a loan to purchase a house. These home loans (commonly known as mortgages) are for large amounts of money and are repaid in monthly installments over a long period of time, typically 30 years. As time passes the value of the home will usually increase (a process known as appreciation), while the total of the mortgage that remains to be paid gradually decreases. The difference between the value of the house and the amount remaining on the mortgage is known as equity. Put another way equity represents the amount of money a homeowner is able to retain after he or she sells the home and pays off the remainder of the mortgage. For example, say a couple purchases a home for $200,000. They pay $20,000 up front (known as a down payment) and then take out a loan for the remaining $180,000. On the day they complete the purchase of the house (also known as the closing), the couple has $20,000 in equity (in other words the original down payment). Two years later their house is valued at $220,000, and the amount remaining on their mortgage is $176,000. In this scenario the couple would have $44,000 in equity on their home. With home equity loans the amount of money a homeowner can borrow depends on the amount of equity he or she has in the house. Traditionally this type of home loan is referred to as a second mortgage.

The two basic types of home equity loans are closed end and open end. A closed-end home equity loan involves a fixed amount of money; the borrower receives the entire amount of the loan (known as a lump sum) upon completing the loan agreement process (or closing). Closed-end home equity loans usually have fixed interest rates (in other words the interest rate remains the same for the life of the loan). Typically the amount of the loan will depend on the amount of equity the borrower has in his or her house; the loan amount might also depend to some degree on the borrower’s credit rating (in other words whether he or she has a proven record of paying off debts in a timely manner). In most cases a borrower is able to borrow up to 100 percent of the equity he or she has in a house. When economists talk about second mortgages they are typically referring to closed-end home equity loans.

With open-end home equity loans, on the other hand, the borrower does not take the lump sum of the loan amount all at once. Instead the borrower receives the loan as credit (that is, as a maximum amount of money he or she can borrow), which the borrower can use as desired. This type of home equity loan is commonly referred to as a home equity line of credit (HELOC). The borrower can take money out of a HELOC at any time and is only required to pay back the amount he or she actually uses. A HELOC is subject to what is known as a draw period, during which the borrower is entitled to borrow money, up to the total amount of the loan, whenever he or she wants. In this way open-end home equity loans give the borrower a greater amount of flexibility. Most open-end home equity loans have variable, or adjustable, interest rates. These rates tend to change over the life of the loan.

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Home Equity Line of Credit – Helpful Home Equity Loan Tips

We’ve all been there: life deals you a bad hand, and unexpectedly you need money you don’t have. At times like this, it’s important to remember the best asset you have: your home. You might consider refinancing as a way to help you through the tough times.

One option you have is a home equity loan. Home equity lines provide homeowners with quick access to extra cash in times of need.

What is a Home Equity Loan?

A home equity line of credit allows you to borrow against the value of your house. The cap on the loan is usually determined by estimating a percentage of the value of your house – 75% or 85% of the house’s value, if your credit is good – and subtracting what you still owe on the first mortgage. Home equity lines usually allow you to draw from the account using special checks or credit cards. The terms of the specific loan will determine the length of the loan, the length of the “draw period” (the period of time during which you can withdraw money on the loan), the interest rates, the minimum and maximum amount that you can withdraw at any one time, and the method and payments with which the loan will be repaid.

For instance, some home equity loans may credit payments only against the interest due on the loan, leaving the borrowed amount to be paid in full at the end of the loan period. Other loans may simply have a larger-than-usual payment, called a balloon payment, as the last payment. However, it may be helpful to note that the interest you pay is usually tax-deductible, meaning that you will get it back on your tax returns; if managed correctly, this “bonus” money can balance the impact of a large final payment on the loan.

In contrast, taking out a second mortgage on your house will give you the borrowed money all at once. Mortgages usually have fixed interest rates, which might be set slightly higher than the introductory rates on a home equity loan. On the bright side, though, the rates and payments on a second mortgage won’t change, whereas the variable interest rates of a home equity loan may mean a payment that increases steadily over the years.

Shopping for a Home Equity Loan

Shopping for a home equity line of credit is like shopping for almost anything else: lots of different lenders provide lots of different choices. In order to make the choice that will best serve your needs, you should be prepared to obtain and compare quotes from many different lenders.

Most home equity loans have variable interest rates, which are determined by an index. When comparing home equity loans, you should know the index that each loan uses to determine your interest rate. Variable interest rates also have a couple of caps that are important for you to know, as they limit how far and how fast the interest rate can rise. The periodic cap limits how much the rate can change at one point in time, and the lifetime cap limits how much the rate can change over the life of the loan. It’s also important to know whether the rate you’ve been quoted is a discounted introductory rate; if so, make sure you know how long the introductory period is, and what the rate will go up to when it’s over.

If you are comparing a home equity line of credit to a second mortgage, understand the differences between them. Primarily, when comparing the costs of both, realize that the APR quoted to you on the second mortgage will be the only cost of the loan, whereas home equity loans also have account fees and other charges that are not built into the APR.

Costs to Consider

“For a true comparison of credit costs, compare other charges, such as points and closing costs, which will add to the cost of your home equity loan,” the Federal Trade Commission (FTC) advises in their document, “Home Equity Credit Lines.” The Truth in Lending Act requires lenders to be open about the terms and costs of a loan, but you may need to ask for this information up front if you are comparison-shopping before committing to any one lender.

o Application fee – In order to qualify for credit, you will have to submit an application to the lender. This application will allow the lender to check your credit score and your debt-to-income ratio, two important factors in determining your credit worthiness. Be aware that your application fee probably won’t be returned to you if you fail to qualify for the loan.

o Appraisal fee – The lender will want to first appraise your house in order to determine the value of the property. From that appraised value, they will determine your line of credit. Appraisal fees can be considerable, and should be compared between lenders as one of the costs of the loan.

o Up-front charges – The lender may assess charges for setting up your account. These charges may vary considerably between lenders, so it’s wise to compare these charges when deciding between multiple home equity loans.

o Closing costs – Just like when you bought your house, you may have to pay closing costs when you get a home equity loan. “These expenses can add substantially to the cost of your loan, especially if you ultimately borrow little from your credit line,” the FTC states. Different lenders feature different closing costs, so any comparison of home equity loans should take these costs into consideration.

o Interest rates – Interest rates determine how much interest you will have to pay over the life of the loan. In order to compare multiple loans, you’ll need to be able to see the “full picture” of what the loan will cost you, which includes the interest rates as well as the other fees and charges the loan will accrue.

o Account fees – Home equity lines often have continuing fees associated with the account, such as transaction fees, maintenance fees, or an annual membership fee. These fees will also vary between lenders, and should be compared as one of the costs of the loan.

Keep in mind that a home equity loan with low interest rates may make up the difference in other costs. For that reason, when shopping for the best deal it’s a good idea to assess all costs associated with each loan.

Using Your Home Equity Line of Credit Wisely

“Because the home is likely to be a consumer’s largest asset, many homeowners use their credit lines only for major items such as education, home improvements, or medical bills and not for day-to-day expenses.” This statement, made by the Federal Reserve Board in their document, “When Your Home is on the Line: What You Should Know About Home Equity Lines of Credit,” reminds us that home equity loans should not be taken lightly. After all, if something goes wrong and you cannot repay the loan according to your terms, you risk losing your most important possession of all: your home.

The FTC notes, “Because home equity loans give you relatively easy access to cash, you might find you borrow money more freely.” The temptation to spend freely will be there, so it will be up to you to remind yourself that you risk losing your home if you let your spending get out of control. Borrow only what you need, and what you know that you can repay according to the terms of your loan. The equity on your home can provide relief in times of difficulty, but if you abuse that privilege, you risk losing the most valuable asset you have.

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