Home equity loans are closely related to home equity lines of credit (HELOCs), but there are subtle differences that make them distinct borrowing entities. Both home equity loans and home equity lines of credit use a consumer’s home as collateral based on the equity built up in the home. Additionally, both of these loan options have favorable interest rates when compared to other forms of borrowing and the interest can be written off on taxes.
Both typically are used to pay off things like home improvement projects, credit card debt, student loans and other forms of debt.
However, there are slight differences that make it important for consumers to examine both opportunities closely before deciding which is appropriate.
Home Equity Loans Act Like A Second Mortgage
A home equity loan gives the borrower a lump sum of money that is paid back over a fixed time and carries a fixed interest rate. In this way, it operates very much like a mortgage or auto loan.
How much you would be able to borrow is based on the amount of equity you have in your home. Equity is defined as the current value of the house minus how much is owed. So, for example, if your home is worth $150,000 and you owe $100,000, then you have $50,000 in home equity.
Most lenders offer 80 percent loan-to-value rates based on the amount of equity in your home. Using the example above, if you have $50,000 in home equity you would likely receive a loan of $40,000 ($50,000 X .80 = $40,000).
The borrower would receive $40,000 in a lump sum for use on whatever project or bill he wished to resolve. Repayments begin immediately on a monthly basis at a fixed interest rate. The rate will vary, depending on the lender and your credit score. The typical repayment period is spread over 25 years. In 2015, home equity loan interest rates average around 6%, with some as low as 4%.
Home equity loans can be very useful if the goal is to gain quick access to money and use it to increase your home’s value or improve your future job prospects by getting a college degree. However, there are downsides that should be considered before making a final decision.
A home equity loans is a secured loan, meaning your house is at risk because you have put it up as collateral. If unforeseen circumstances arise like a job loss or serious medical condition and you are unable to make payments, your home could go into foreclosure.
There is the matter of closing costs and interest rate charges that can add up quickly if you already are paying a mortgage. There also is the possibility of an early-termination fee, if you decide to pay it off early.
Another serious issue is volatility in the real estate market. Home equity is not static, meaning if the market plunges, like it did in 2008, home values can decrease, affecting the equity you have in your home. When volatile markets affect home equity, it can make it very difficult to sell your home.
If the real estate market in your area is prone to dramatic swings, it may be wise to consider other options, such as mortgage modifications, as an alternative to home equity loans.