Using the roof over your head as collateral for cash has become an extremely popular and efficient way to borrow money. A home equity loan uses the equity you've built in your home - that is, the difference between your home's appraised (fair market) value and your outstanding mortgage balance - as collateral against which you can borrow money. For this reason, home equity loans are considered the same as second mortgages. And since your home is on the line, it is important to understand both the opportunities and the consequences of home equity borrowing.
Often a home is your largest single investment and your most valuable asset. A home equity loan provides a way to tap into that asset to make the most of your investment. Home equity loans, or second mortgages, are loans secured by a second lien on a personal residence. These loans allow you to conveniently leverage, or borrow against, the equity in your home. Home equity loans can be used for myriad purposes. Some of the most popular include financing college tuition, making home improvements, or purchasing a luxury item such as a boat or vacation home. Home equity loans are also a very popular method of consolidating debt, since you can pay off your high-rate credit card balances and replace them with a lower rate equity loan. The interest you pay on your home equity loan is often tax-deductible, which magnifies your savings.
Types of Equity Loans
There are two types of equity loans and lines of credit: term and closed-end. Both are typically used for a shorter term than the original mortgage you used to buy your home. For example, first mortgages can run up to 30 years, while equity loans typically have a life of 5 to 15 years. A term 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 a fixed payment each month. Alternatively, the home equity line of credit works more like a credit card. You are allowed to borrow up to a certain amount for the life of the loan and withdraw money as you need it. As you pay off the principal, your credit revolves, and you can use it again. This offers more flexibility than a term loan. While term loans have fixed rates, a home equity credit line often has a variable interest rate that fluctuates over the life of the loan. Payments will vary depending on the interest rate and how much credit you have used. When the term of the line of credit expires, everything must be paid off.
Following is a comparison of the main features of home equity loans and lines of credit:
|Home Equity Line||Home Equity Loan|
|Collateral/ Security Interest||Home||Home|
|Interest Rate||Variable||Generally Fixed|
|Monthly Payment Amount||Variable||Generally Fixed|
|Due in Full if Home Sold||Yes||Yes|
|Annual Renewal Fee||Sometimes||No|
|Funds Taken in Lump Sum||No||Yes|
|Fixed Repayment Term||No||Yes|
Interest-only Payment Plans Available
|Preset Credit Limit||Yes||Yes|
|Credit becomes Available as Loan is Repaid||Yes||No|
As with any mortgage, there are costs associated with acquiring a home equity loan or line of credit. These costs can vary by state and usually include fees for appraisal and recording, flood searches, credit reports, and lien searches. Many lenders will absorb some or all of these costs. If the amount of credit requested exceeds $100,000, you will usually be asked to pay for the cost of a full appraisal of your home to determine its current market value.
It Pays To Be Prudent
It used to be that you actually needed some equity in your home to qualify for a home equity loan. Not so anymore. In the past few years, the allowable loan amount (as a percentage of the value of the home) has increased from 75% or 80% up to 100% and more. This allows borrowers to fully mortgage one of their largest assets to invest or make purchases. You could find yourself borrowing against your home for more than it's worth.
To be cautious, your total income and other outstanding loans and credit record should be considered along with the home appraisal to determine the appropriate loan amount and your capacity to make the monthly payments. As always, your total monthly debt should not exceed 36% of your gross monthly income.
Remember that if your home is ever sold, the outstanding balance on the home equity loan will be due in full, with no prepayment penalties. The remaining amount of principal and interest due (the payoff) on a home equity loan should be factored into any calculation of net equity (the difference between the fair market value of the property and the balance of any and all mortgages secured by the property). This is especially important if the equity in the home will be used as a down payment on a new home.
With these cautions in mind, a home equity loan or line of credit can be a very effective way to tap into the equity of your home and borrow some needed money. Home equity loans are flexible, can be used for a variety of purposes, and often offer tax benefits as well. Remember, however, that the roof over your head is the basis for the loan, and it is wise to be prudent with your most valuable investment.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.