Home equity loans give homeowners the option of borrowing against the part of the home they actually own, or their home equity. Home equity loans are also known as second mortgages. Your home is the collateral on the loan, and is on the line if you default on the loan.
To find the equity in your home, subtract the amount of your mortgage from the value of the house. For example, if you have a $100,000 house and have $60,000 left on the mortgage, you have $40,000 of equity. This is the amount available to borrow against for home equity loans.
Home equity loans actually reduce your ownership in your home. If you take out a $30,000 home equity loan on this same house, your ownership is now reduced to only 10 percent of the home. Remember, if you default on home equity loans, you could lose your house.
However, home equity loans come with some major benefits. Because home equity loans are secured by the homes themselves, you are rewarded with lower interest rates. Also, the interest paid on home equity loans is tax deductible. Consult with your tax adviser for all the information and tax benefits of home equity loans.
Home equity loans come in a few different forms. The standard home equity loan is a lump sum with a fixed interest rate and fixed monthly payments. You may choose to take out a home equity line of credit, in which the lender gives you a line of credit based on the equity in your home and you can take out variable amounts at different times, somewhat like a credit card. The interest rate can change with the amount you take out and the times at which you use the credit. Another option is cash-out refinancing, in which you take advantage of lower interest rates and actually refinance your first mortgage for a new one at possibly a higher amount, and use the extra cash without raising your monthly payments.
Discuss the various home equity loans with your lender and which option is best for you. You may find you should simply refinance rather than take out a second mortgage, or you may decide to borrow using the equity you have built up over the years.
Lenders will evaluate you on many different aspects when you apply for home equity loans. They will look at your credit rating, your debt-to-income ratio, your employment history, your past payment history and other factors. Lenders also evaluate your application for home equity loans on the loan-to-value ratio. This is the total amount you have borrowed, divided by the value of the home. They generally like to keep the LTV ratio around 80 percent, so if you have your $100,000 home and have $60,000 in equity, you may borrow up to about $40,000, because that would put the lender at the 80 percent LTV ratio.
It is a good idea to use home equity loans for something that does not depreciate in value or something that creates an asset, such as education, debt consolidation, education, home improvements, etc. It is generally not a good idea to use home equity loans for cars, vacations or luxury items, as these only depreciate, and you will be paying interest and could stand to lose your home if you default on the payments.
When you are shopping for home equity loans, watch out for prepayment penalties, especially if you are planning to move in the next few years. These prepayment penalties can be painful to your pocketbook if you pay off your loan early. Also, do not sign onto home equity loans with balloon payments. You will be required to make a large lump sum payment at the end of the loan, and if you cannot make the payment, the lender will foreclose on your property. One other word of caution: be wary of special introductory rate home equity loans. These low rates will usually only be effective for a few months and then rise sharply.
Finally, do not be afraid to negotiate with your lender on home equity loans. Ask them if they will lower the interest rate, waive or reduce one or more of the fees or lower the points you are required to pay on home equity loans. Be sure if they concede to lower one option, they do not raise another. Competition is steep and they will more than likely be willing to give you a better deal if you will just ask.
D. Blair Thompson
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