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Home Equity Loans Explained

by Kathleen Seligman

You’ve probably seen the commercials, or received the phone calls as you ate dinner, encouraging you to apply for a home equity loan. These advertisements exhort you to take advantage of the equity in your home in order to reshape your debt. With the money from a home equity loan you can consolidate the money you owe to various sources, such as credit card companies, by paying them off and turning many smaller bills into a single, more easily managed one. Home equity loans can also be used for unexpected expenses related to home repair or improvements, education, and medical emergencies.

What Is A Home Equity Loan?

A home equity loan is a secured loan that allows you to borrow money using your home as collateral. This means that if after taking out a home equity loan you are unable to repay the amount you borrowed, your house can be repossessed and sold to repay the loan.

Home equity loans, also known as second mortgages, use the amount of equity in your home to determine the amount of money you can borrow. Your home’s equity is the difference between how much your house is worth and how much money you still owe on your original mortgage. For instance, if you made a $10,000 down payment when you purchased your $200,000 house, you would have needed to borrow $190,000. Your initial equity is therefore the same as your down payment. After several years of faithfully making your mortgage payments, however, you may have paid down your mortgage’s principal by $30,000 and thereby reducing your loan to $160,000. Now the equity in your home is the original $200,000 - $160,000, or $40,000. If your home’s value increased during this time, that additional amount is added to your home’s equity.

Another example:

Original cost of house: $200,000
Amount borrowed: - 190,000
Down payment/equity: $10,000

10 years later
Amount borrowed: $190,000
Principal paid: - 30,000
Amount owed: $160,000

House’s appraised value: $300,000
Amount owed: - 160,000
Equity: $140,000

Aside from simply gaining access to a potentially substantial amount of money to answer your financial needs, home equity loans have some additional benefits as well. Unlike with credit cards, the interest you pay on your home equity loan is tax-deductible. This interest rate will also likely be much lower than those of credit cards since a home equity loan is backed by your home as collateral.

How Do You Apply For A Home Equity Loan?

Since home equity loans use your house as collateral, these are the easiest loans to obtain. Even individuals with poor credit or large amounts of debt can easily qualify for home equity loans as long as they possess enough equity in their house.

As those numerous television commercials and phone calls prove, there are many different lending agencies, as well as types of home equity loans, to consider. In order to find the best home equity loan to fit your circumstances, you’ll need to shop around and collect several different loan quotes. Traditional sources of home equity loans include banks, mortgage companies, and credit unions. These institutions, however, often prefer to work with applicants with moderate to high credit ratings and may be hesitant to approve home equity loans for people with not so perfect credit.

If your credit history isn’t stellar, you might consider applying for a home equity loan through a mortgage broker. Such brokers have access to loans geared specifically for those with poor or no credit history.

Just like with personal and auto loans, you can also apply for a home equity loan over the Internet. Home equity loan websites will ask for information about your credit history, current mortgage, and the amount of equity in your home as well as how much of it you’re looking to borrow. Certain sites will collect several home equity loan offers that you may choose from.

After you have collected quotes from various possible home equity loans, one of the first things you’ll need to consider is their interest rate. Obviously, the lower the rate, the less money you will need to pay, but a low interest rate may be deceptive. Unlike other loans, home equity loans can come with many fees and hidden costs that can reduce the amount of money you can use from your loan. For instance, before approving your loan, most lending agencies require that you have your house appraised to determine how much its value has increased. Home appraisals are not free, and you will likely be responsible for the bill. Additional lender fees, processing fees, and transaction fees can also be tacked onto your home equity loan and can cost you thousands of dollars.

Remember, no matter which home equity loan you ultimately decide on, make sure you thoroughly read and understand any accompanying fine print.

How Do You Repay A Home Equity Loan?

Once you are approved for your home equity loan, you’ll receive the money in one lump sum. After receiving your loan amount, you will need to begin repaying the money in regular monthly payments against the home equity loan and its fixed interest rate. During this repayment period, you cannot borrow additional money from the loan, but must work to pay back the complete amount before the loan’s term expires. If you decide to sell your home before the home equity loan must be repaid, then you are required to pay off the loan from the money you make on the sale.

Unlike your original first mortgage, which was likely set up to be repaid over a period close to 30 years, second mortgages or home equity loans are often designed with a shorter lifespan in mind. Home equity loans are normally approved for between 5 and 15 years, though some can be negotiated for as long 30 years. Current fixed interest rates range from 6.17% for a 15-year loan and 6.58% for one set to last 30 years. Naturally these rates are only general estimates and can vary depending on your financial history, the amount you plan to borrow, and the institution granting your home equity loan.

Home equity loans can be fairly easy to obtain and are extremely useful when it comes to consolidating debt or paying off large unexpected expenses. Just remember, though, to be careful. Before applying for a home equity loan, make sure that you’ll be able to make the payments. It’s never good to default on a loan, but whereas failing to repay a personal or auto loan can result in bad credit as well as the loss of your car, you will lose your house if you should prove unable to keep up with your home equity loan payments.

As with all loans, knowledge is the ultimate power, and the more you understand the ins and outs of home equity loans, the more beneficial your borrowing experience will be.

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