Another nice benefit to home equity loans versus other types of loans is that they tend to carry relatively low interest rates. In addition, most companies that offer home equity loans, have a large diversity of different home equity products to offer, enabling you to find the program that has terms most suited for your needs. What's more, closing costs on home equity loans are typically very small compared to closing costs associated with refinancing. For more indepth information on home equity lines of credit, what they entail, what the pros are, as well as what the risks are, read the article below.
Home Equity Basics
from www.bankrate.com
A home equity loan or line of credit allows you to borrow money, using your home's equity as collateral.
Wait. Don't click to another page. If the above paragraph seems like gibberish, you have surfed to the right place. We will explain what home equity is, what collateral is, how these loans and lines of credit work, why people use them, and what pitfalls to avoid.
First, some definitions:
Collateral is property that you pledge as a guarantee that you will repay a debt. If you don't repay the debt, the lender can take your collateral and sell it to get its money back. With a home equity loan or line of credit, you pledge your home as collateral. You can lose the home and be forced to move out if you don't repay the debt.
Equity is the difference between how much the home is worth and how much you owe on the mortgage (or mortgages, if you have more than one on the property).
Example: Let's say you buy a house for $200,000. You make a down payment of $20,000 and borrow $180,000. The day you buy the house, your equity is the same as the down payment -- $20,000: $200,000 (home's purchase price)
- $180,000 (amount owed) = $20,000 (equity).
Fast-forward five years. You have been making your monthly payments faithfully, and have paid down $13,000 of the mortgage debt, so you owe $167,000. During the same time, the value of the house has increased. Now it is worth $300,000. Your equity is $133,000: $300,000 (home's current appraised value) - $167,000 (amount owed) = $133,000 (equity)
A home equity loan (or line of credit) is a second mortgage that lets you turn equity into cash, allowing you to spend it on home improvements, debt consolidation, college education or other expenses.
There are two types of home equity debt: home equity loans and home equity lines of credit, also known as HELOCs. Both are sometimes referred to as second mortgages, because they are secured by your property, just like the original, or primary, mortgage.
Home equity loans and lines of credit usually are repaid in a shorter period than first mortgages. Most commonly, mortgages are set up to be repaid over 30 years. Equity loans and lines of credit often have a repayment period of 15 years, although it might be as short as five and as long as 30 years.
A home equity loan is a one-time lump sum that is paid off over a set amount of time, with a fixed interest rate and the same payments each month. Once you get the money, you cannot borrow further from the loan. Bankrate surveys home equity lenders and is a good source for current rates.
A home equity line of credit, or HELOC, works more like a credit card because it has a revolving balance. A HELOC allows you to borrow up to a certain amount for the life of the loan -- a time limit set by the lender. During that time, you can withdraw money as you need it. As you pay off the principal, you can use the credit again, like a credit card.
Example: Let's say you have a $10,000 line of credit. You borrow $5,000 to pay for new kitchen cabinets. At that point, you owe the $5,000 you borrowed, and you have $5,000 remaining in your credit line, meaning that you could borrow another $5,000.
Instead of borrowing more from the line of credit, you pay back $3,000. At this point, you still owe $2,000, and you have $8,000 in available credit.
A HELOC gives you more flexibility than a fixed-rate home equity loan. It also is possible to remain in debt with a home equity loan, paying only interest and not paying down principal.
Home equity loans and lines of credit have become increasingly common since the mid-1980s as property values have soared and homeowners learned about managing their personal debt. Among the reasons for this surge in popularity: attractive interest rates and tax deductibility.
Equity rates
Because home equity loans and credit lines are secured by one's personal residence, lenders consider them almost as secure as primary mortgages. While equity rates generally are higher than rates on primary mortgages, they usually have lower rates than credit cards and auto loans.
Average rates for home equity loans and lines of credit are available from Bankrate.com's current rates of 4,000 financial institutions around the country.
Tax deductibility
Way back in the disco era, most interest on consumer debt was tax-deductible. That was good news for people who got auto loans in the '80s for Pintos and Fieros equipped with the latest eight-track stereo technology. But it was a bad deal for the federal government, which, by the mid-1980s, was hip deep in budget deficits. To reduce the need to raise income tax rates, Congress and President Reagan yanked the tax deduction for consumer interest. Except for mortgage debt. The deduction for mortgage interest remained. That goes for home equity debt up to $100,000.
Another route
While home equity debt has grown in popularity, getting an equity loan or line of credit isn't the only way to extract cash from one's castle. There is also the "cash-out refinance." For a cash-out refi to make sense, mortgage rates have to have dropped, and property values must have risen. This was the case for millions of homeowners in the early years of the 21st century, and cash-out refis were legion.
With a cash-out refi, you refinance the primary mortgage for more than the outstanding balance. Let's say you bought a house for $100,000 a few years ago, and now you owe $70,000. But the home has doubled in value over the years, so it's worth $200,000. You could do a cash-out refi of $150,000. You would pay off the $70,000 outstanding mortgage and take $80,000 in cash. Of course, you could only do this if you could afford payments on a $150,000 mortgage. You can also compare mortgage refi rates to home equity rates.
A line of credit has a variable interest rate that fluctuates over the life of the loan. Payments vary depending on the interest rate, the amount owed, and whether the credit line is in the draw period or the repayment period.
During the equity line's draw period, you can borrow against it, and the minimum monthly payments cover only the interest, although you can elect to pay principal.
During the repayment period, you can't add new debt and must repay the balance over the remaining life of the loan.
The draw period often is five or 10 years and the repayment period typically is 10 or 15 years. Those are generalizations, and each lender can set its own draw and repayment periods. Lenders have been known to have draw periods of nine years, six months, and repayment periods of 20 years. Bankrate surveys home equity line of credit lenders for their current rates.
A line of credit is accessed by check, credit card or electronic transfer ordered by phone. Lenders often require you to take an initial advance when you set up the loan, withdraw a minimum amount each time you dip into it and keep a minimum amount outstanding.
With either a home equity loan or a line of credit, you have to pay off the balance when you sell the house.
So far, you have learned what equity is and that there are two kinds of equity debt: home equity loans and home equity lines of credit, or HELOCs. Equity loans are provided in a lump sum, and they are paid off in equal monthly installments over a set period. Home equity lines of credit have revolving balances and work like a credit card.
Rates for equity debt tend to be relatively low, and the interest payments are tax deductible. There is another way to extract cash from a home's equity, and that's the cash-out refinance, which shares the same rate and tax advantages that equity loans and credit lines have.
Next, we will discuss the decisions to be made before you seize your home's equity: what to do and what not to do with the money and, most crucial, which type to get -- an equity loan or a line of credit.
