Using a home equity loan to borrow against the equity in your home has become a popular source of consumer credit. And lenders are offering these home equity loans in a variety of ways.
You will find that traditional home equity loans come with fixed rates while most home equity credit lines come with variable interest rates, some come with attractive low introductory rates. You also may find most loans have large one-time upfront fees, others have closing costs, and some have continuing costs, such as annual fees. You can find home equity equity loans with large balloon payments at the end of the loan, and others with no balloons but with higher monthly payments. No one loan is right for every homeowner. The challenge, then, is to contact different lenders, compare options, and select the home equity loan best tailored to your needs.
Why are home equity products so attractive? They offer homeowners great flexibility to finance major expenses, including home improvements and college tuition. They usually have a lower interest rate than credit cards, and the interest often is tax deductible (check with your tax advisor). But these loans also come with risks. The most important thing to remember is that your home is collateral for the loan. That means if you run into repayment difficulties, the lender could elect to foreclose on your loan and you may lose your home. So, before you put your home at risk, you should learn more about how home equity loans work and what can go wrong if they are not used carefully.
What is a Home Equity Loan? The "traditional" home equity loan (HEL) is a one-time loan for a lump sum, and typically at a fixed interest rate. The loan is repaid in equal monthly payments over a set period of time. A home equity line of credit (HELOC) is very different because it works like a credit card. You receive a line of credit from which you can draw money. As you repay the principal, your available credit goes up again, just like a credit card. Typically, the interest rate on a line of credit is variable, meaning that it is tied to an index and will change with movements in interest rates. With both types of home equity products not only could you lose your home if you can't repay the debt, but you also are at risk if there is a drop in the value of your home. Although the housing market has done extremely well in recent years, there is always a chance that real estate values will go down.
Is a Home Equity Loan for you? If you need to borrow money, home equity lines may be one useful source of credit. Initially at least, they may provide you with large amounts of cash at relatively low interest rates. And they may provide you with certain tax advantages unavailable with other kinds of loans. (Check with your tax adviser for details.) At the same time, home equity loans require you to use your home as collateral for the loan. This may put your home at risk if you are late or cannot make your monthly payments. Those loans with a large final (balloon) payment may lead you to borrow more money to pay off this debt, or they may put your home in jeopardy if you cannot qualify for refinancing. And, if you sell your home, most plans require you to pay off your credit line at that time. In addition, because home equity loans give you relatively easy access to cash, you might find you borrow money more freely.
How much money can you borrow on a Home Equity Loan? Depending on your creditworthiness (your income, credit rating, etc.) and the amount of your outstanding debt, home equity lenders may let you borrow up to 80- 85% of the appraised value of your home minus the amount you still owe on your first mortgage. Ask the lender about the length of the home equity loan, whether, in the case of a HELOC, there is a minimum withdrawal requirement when you open your account, and whether there are minimum or maximum withdrawal requirements after your account is opened. Inquire how you gain access to your credit line -- with checks, credit cards, or both.
Also, find out if your home equity plan sets a fixed time -- a draw period -- when you can make withdrawals from your account. Once the draw period expires, you may be able to renew your credit line. If you cannot, you will not be permitted to borrow additional funds. Also, in some plans, you may have to pay your full outstanding balance. In others, you may be able to repay the balance over a fixed time.
Beware of Interest Rate Fluctuations. HELOCs often come with extra-low interest rates for an introductory period, such as six months, but these are variable rates that could go up during the life of the loan. When deciding whether a line of credit is right for you, ask yourself if you can afford the increased monthly payments after the introductory period ends or when interest rates rise. You'll also have to decide if you are comfortable with a fluctuating monthly mortgage payment or whether a fixed interest rate and stable payments are better for you.
What are the upfront closing costs? When you take out a home equity loan, you pay for many of the same expenses as when you financed your original mortgage. These include items such as an application fee, title search, appraisal, attorneys' fees, and points (a percentage of the amount you borrow). These expenses can add substantially to the cost of your loan, especially if you ultimately borrow little from your credit line. You may want to negotiate with lenders to see if they will pay for some of these expenses.
Cancellation Rights. You have specific rights if you're using your home as security for a home equity loan or line of credit. Federal law gives you three business days after signing the loan papers to cancel the deal?for any reason?without penalty. You must cancel in writing. The lender also must return any fees or finance charges you had paid. This right doesn't apply if you are refinancing or consolidating existing loans without borrowing additional money.