by Amy Lillard
A home equity loan puts your house to work for you, creating a personal loan borrowed against the value of your home.
To understand home equity loans, borrowers need to first understand the concept of equity. Simply stated, equity is the difference between how much your home is worth and how much you owe. Let's say you have bought a house for $300,000. Your down payment is $30,000. On the day you buy the house, your equity is the value of your home minus the amount you still owe - $30,000.
Five years later, you have made payments monthly and paid around $19,000. You still owe $251,000. But during these five years your home has increased in value, to $400,000. Your equity is the home's current appraised value ($400,000) minus the amount you still owe ($251,000). Your equity in your home is now $149,000.
Home equity loans seek to free up this extra amount that exists within your equity. It is a loan that serves as a low-interest source of cash to pay off higher-interest debts or pay for home improvements, educational tuition, medical bills, weddings, and more.
To procure loans you usually need collateral, and home equity loans are no different. Collateral is property you use as a guarantee to repay a debt. In a home equity loan, you are pledging your home as collateral. Thus, home equity loans must be carefully considered and undertaken - if you do not repay the debt you incur with home equity loans, your home can be taken and sold.
With this second type of home equity loan, you have options on how to repay the loan. You can opt for normal payments covering both the interest and principal, interest-only payments, and optional size payments.
Home equity loans are increasingly popular because they have significant beneifts over other loans or credit card use. While the rate on home equity loans is usually higher than a regular, or first, mortgage, the rate is generally much lower than credit card and other loan rates. In addition, you are repaying home equity loans over a longer amount of time, resulting in smaller monthly payments. Interest on home equity loans is usually tax-deductible. Consult your tax adviser for details.
While home equity loans are increasingly used by homeowners to boost their purchasing power, there are significant risks. As mentioned above, with your home as collateral you face some stiff punishment for defaulting on loans. For this reason, home equity loans should be used only for large purchases important to you and your family, and only in amounts that you can afford. Home equity loans can also have some surprising small print that can increase the risk for borrowers. Borrowers face a range of often-expensive closing costs, just as for your first mortgage.
A final risk is something called “reloading.” Borrowers may opt to take out a home equity loan to pay off high-interest credit card balances. A smart idea, resulting in lower monthly payments and smaller interest. However, some borrowers make the mistake of reusing the credit card, “reloading” their balance and increasing their debt. The best tactic is to close or store paid-off credit cards in this instance.