A home equity loan is a loan that is secured by your home.
Such loans may be in addition to other loans you have against your
home, or, if you own your home free and clear of debt. There
are two basic types of equity loans. Standard loans refer
to loans that give you a lump sum amount at the beginning of the
loan. They are repaid over a specific period of time, and, at the
end of that time, your balance is zero. They are generally at a
fixed interest rate and are sometimes called “second mortgages.” The
other type of home equity loan is a credit line. Most credit
lines have a variable or adjustable interest rate, and they operate
similarly to a credit card. The amount you are authorized to borrow
is like the limit on a credit card. You can borrow as much or as
little of that amount as you wish during the “draw period.” Credit
line loans often have “interest only” payments that are very low.
But if you are paying interest only, then at the end of the loan
period the amount owed will be the total amount of the funds you
borrowed, unless you have paid additional payments toward the principle.
There are big differences between these two types of loans. The
home equity credit line is so much riskier than the standard loan
that lenders are required by the federal Truth in Lending Act to
give applicants an information booklet entitled “When your home
is on the line, what you should know about home equity lines of
credit.” This should be read carefully to understand the risks involved
with line of credit loan.
Pros
In most cases, interest payments for your home equity mortgage on your primary
residence are tax deductible.
It may be easier to get a home equity loan because the repayment of the
loan is secured by your home.
The payments may be low because the debt extends over a long term, or because
your payment may be interest only for a period of time, after which your
payments may increase greatly.
Loans that are secured by property usually have a lower interest rate than
unsecured loans.
A credit line loan allows you to draw upon it when the need arises without
going through a loan approval process.
Many home equity loans are available with no closing costs.
Cons
If you pay only the required payment on your equity line each month at the
end of the loan you can end up owing an amount close to the original amount
of the loan.
Any closing costs for the home equity loan that are added to the loan amount
will cost more in interest paid, and it will take you longer to repay the
loan.
Your credit score will be affected due to the added debt.
If the value of your home goes down, you may end up owing more on your home
than what you can get if you sell it.
A credit line loan often has an adjustable interest rate that can increase
your payments greatly over the term of the loan.
The home equity credit line is very similar to having a credit card with
an enormous limit. Therefore credit line loans make it very easy to overspend
or use credit for things better saved for.
Transferring your credit card debt and car payments to a home equity line
may lower your monthly payment, but the debt is now secured by your home.
Qualifying for a certain loan amount does not necessarily mean that you
can afford it.
If you are not able to repay the home equity loan for any reason such that
you fall behind in your payments, you risk losing your home.
What to Avoid
Avoid lenders who want you to make a quick decision.
Avoid loans with high late fees, annual fees, and prepayment penalties.
Avoid borrowing more than your home is worth or more than you need. Some
aggressive lenders get a “padded” appraisal for the amount they need in
order to make the loan. Be aware that such appraisals are not a true reflection
of the price for which you could sell your home.
Avoid agreeing to loan insurance without first consulting a qualified insurance
agent who may be able to obtain the same coverage for less and not have
it tied to your home loan.
What to Look for
Apply to at least 3 different lenders and get a good faith estimate quote
from each for the cost of getting the loan. Compare the three quotes and
ask questions. Get a qualified professional that is not associated with
the lender to explain all of the terms to you.
Have the lender explain adjustable rates, how they work, and what your payment
will be at the maximum rate.
If you chose a home equity line of credit, make sure your budget allows
you to pay far more than the “interest only” payment.
Remember you have three days to change your mind after signing loan papers
involving the refinance of your primary residence.
Make sure you understand how a “balloon feature” works, whether it is right
for your situation and what your options will be when the balance comes
due.
Shop and compare interest rates.
Find out if there is a minimum amount you are required to borrow under a
credit line loan.
