How Home Equity Loans Work

If you're a homeowner, and you want to understand how Home Equity Loans work, I'll explain it to you. You can borrow against the equity value of your house through either a home equity line of credit (often called a HELOC or a line) or a home equity loan (often called a HEL or loan). Both are essentially a second mortgage.

With Home Equity Loans, you receive a lump sum of money and have a fixed monthly payment. You pay off this Home Equity Loan over a predetermined time period, such as 10 years or 15 years. The amount you can borrow with Home Equity Loans is based on factors such as your income, debts, the value of your home, how much you still owe on your mortgage (1st and/or 2nd) and your credit history. It's also a good choice if you have a specific purpose for the loan such as debt consolidation or home renovation, which requires a set amount of money.

The appeal of how Home Equity Loans works is in the interest rate, which is almost always lower than those of credit cards or conventional bank loans because they are secured against the equity value in your home. In addition, the interest you pay on Home Equity Loans is often tax deductible (consult a tax advisor about your particular situation).

Home Equity Loans usually carry a higher interest rate than that of a first mortgage. With a Home Equity Loan, you may choose either an adjustable rate that fluctuates according to variations in the prime rate, or you may choose a fixed rate. A fixed rate enables you to budget a set monthly payment without worrying about increasing costs should interest rates rise. With Home Equity Loans, there are also closing costs that you should consider.

Keep in mind, your home is the collateral for your Home Equity Loan. If a Home Equity Loans easy access to cash tempts you to run up more debt than you can repay, or if you fail to make your monthly payments, you risk losing your home.

Here are the components of Home Equity Loans:

• What you get is a fixed amount of money, up to 100 percent of your equity value in your home (its value minus your first mortgage debt and other debts). Some lenders will allow you to borrow up to 125 percent of the value of your home.
• How you qualify is you typically need to provide proof of your income and home ownership, and proof that at least 20 percent of the value of your home is paid off. An appraisal is usually required as well.
• How you pay it is fixed payments of interest and principal over a fixed period of time.
• The term of the mortgage can be as short as 1 year or as long as 30 years.
• There are closing costs that are lower than closing costs for a first mortgage.
• You receive one up-front lump sum.
• A fixed or adjustable interest rate.
• Interest may be tax-deductible (consult a tax advisor).

Home Equity Loans are a good way of getting needed funds at an affordable rate. But, as with all types of debt, it's wise to avoid borrowing more than you can repay. Remember that since the loan is secured by your house, the lender could foreclose on your home if you don't repay the money. If you're not comfortable with that risk, conventional bank loans might be a better choice.

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