Home Equity Loans

Home Equity.

If you’re a homeowner in need of money, and have accumulated equity in your property, you may be able to convert this equity into cash. People choose to draw on their home equity because loan rates are significantly lower than other types of borrowing, like personal loans or credit cards. There are also tax advantages associated with home equity loans, because the interest may be tax deductible within certain limitations. Another reason that home equity loans are appealing is that closing costs are relatively low.

Home equity loans are also known as second mortgages because they are subordinate to your primary mortgage. If you can’t afford to make your mortgage payments and subsequently default, the first mortgage gets paid off first from any proceeds of a sale. As a result, there is much more risk for lenders who give you a home equity loan.

Understanding the different types

There are two types of second mortgages: the home equity loan, which is also known as a HEL, and the home equity line of credit, which is also called a HELOC.

A home equity loan is a fixed-rate loan, where the lender will give you a lump sum of money, and you pay it back during a specified period of time. Payments are higher than they would be with a HELOC, because each month, you’re paying interest and principal. They are most appropriate if you’re borrowing for a project where you know exactly how much money you’ll need, and you like the consistency of a steady monthly payment. One great advantage of a HEL over a HELOC is that you will continue to build equity in your home each month as you pay the loan back.

A HELOC offers much more flexibility than its second mortgage counterpart. A lender will give you a line of credit, which you can draw from on an as-needed basis. It functions a lot like a credit card, except that the interest rate is lower. HELOCs have a variable interest rate that is tied to an index, like the prime rate or the LIBOR, and will change every month. You’ll be allowed to take money out during the draw period, which is generally about 10 years. Most banks allow you to pay interest only during the draw period. However, if you choose that path and don’t pay down your principal, it will continue to accumulate. At the end of the draw period, you’ll be required to pay back any remaining principal either as a lump sum, or on an amortized basis, and will no longer be able to withdraw any additional funds.

There are some major drawbacks with HELOCs. One is that if you make payments of only interest, you’re not building any home equity. The second is that, because the interest rate is variable, you have no idea how to budget for the HELOC expense.

How much can you borrow?

Most banks will allow you to borrow up to 80 percent of the available home equity in your property. To calculate that amount, determine the current value of your home. Your next step is to subtract the value of your current mortgage. Divide the number by 80%, and bingo … you now have the maximum amount of home equity that you may be qualified to borrow against.

Advantages and disadvantages of home equity loans

Both home equity loans and HELs offer several advantages when compared to other types of borrowing. First, the application process is much quicker than with a traditional loan. Some banks may even approve you on the spot if you don’t want to borrow too much and you have a good credit report.

Second, home equity loans can be amortized for up to 30 years, which can make your monthly payments much easier to manage. Third, interest is generally tax-deductible, and interest rates are lower than with other comparable borrowing opportunities. Finally, if you have a large amount of equity accumulated in your home, you have access to a significant sum of cash.

So far, everything sounds good. But there are many risks associated with home equity loans. The biggest drawback is that if you can’t make your payments, a bank could foreclose on your property. If you make late payments, you may be hit with hefty fees. Banks will report your tardiness to the credit reporting agencies, and your credit rating could take a big hit. And even though mortgage rates for home equity loans are lower than credit card rates, they will be significantly higher than rates for traditional mortgages.

Another risk that’s associated with HELOCs is that when the rate adjusts, you may not be prepared for the higher payments. Say, for example, that you borrow against your line of credit to send your child to college when interest rates are low – in the 4 to 5 percent range. Then you find yourself in an environment where interest rates are rising, and you’re now paying 7 to 8 percent interest. If you’re not prepared, you could find it difficult to make the higher monthly payment.