| A home equity loan is a type of loan in which the borrower uses the equity in his home as collateral. These loans are sometimes useful for families to help finance major home repairs, medical bills or college educations. A home equity loan creates a lien against the borrower's house. A home-equity loan, also known as a second mortgage, lets homeowners borrow money by leveraging the equity in their homes. Home-equity loans exploded in popularity in 1996 as they provided a way for consumers to somewhat circumvent that year's tax changes, which eliminated deductions for the interest on most consumer purchases. Home equity loans are most commonly second position liens, although they can be held in first or, less commonly, third position. Most home equity loans require good to excellent credit history, and reasonable loan-to-value and combined loan-to-value ratios. Home equity loans come in two types, closed end and open end. |
Types of Home Equity Loan Closed end home equity loan The borrower receives a lump sum at the time of the closing and cannot borrow further. The maximum amount of money that can be borrowed is determined by variables including credit history, income, and the appraised value of the collateral, among others. It is common to be able to borrow up to 100% of the appraised value of the home, less any liens, although there are lenders that will go above 100% when doing over-equity loans. Open end home equity loan This is a revolving credit loan, also referred to as a home equity line of credit (HELOC), where the borrower can choose when and how often to borrow against the equity in the property, with the lender setting an initial limit to the credit line based on criteria similar to those used for closed-end loans. Like the closed-end loan, it may be possible to borrow up to 100% of the value of a home, less any liens. These lines of credit are available up to 30 years, usually at a variable interest rate. The minimum monthly payment can be as low as only the interest that is due. Benefits of Home Equity Loan Benefits for Consumers Home-equity loans provide an easy source of cash. The interest rate on a home-equity loan - although higher than that of a first mortgage - is much lower than on credit cards and other consumer loans. As such, the number-one reason consumers borrow against the value of their homes via a fixed-rate home equity loan is to pay off credit card balances. Interest paid on a home-equity loan is also tax deductible, as we noted earlier. So, by consolidating debt with the home-equity loan, consumers get a single payment, a lower interest rate and tax benefits. Benefits for Lenders Home-equity loans are a dream comes true for a lender, who, after earning interest and fees on the borrower's initial mortgage, earns even more interest and fees. If the borrower defaults, the lender gets to keep all the money earned on the initial mortgage and all the money earned on the home-equity loan; plus the lender gets to repossess the property, sell it again and restart the cycle with the next borrower. From a business-model perspective, it's tough to think of a more attractive arrangement. Drawbacks of Home Equity Loan Although home equity loans can be used to pay off debt, fund a college education, or pay for a nice vacation, there are certain things you should be aware of, such as the following: Watch out for home equity loans that offer a very low introductory rate that increases dramatically to a very high regular rate.
Find out if the loan comes with prepayment penalties. You might want to pay off the debt as fast as possible and don't want prepaymentprovisions to prevent you from doing this.
Variable rate loans must have a cap that sets an upper limit that the interest rate cannot rise above. If this cap is ever reached, the lender has the right to shut down the line of credit.
A lender can call in the loan and demand full repayment if your home loses a significant amount of value. Similarly, if your income decreases or your financial health suffers, the lender can cancel a home equity line of credit.
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Home Equity Loan
