Home Equity Loans: The Risks & Rewards Can be Enormous

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The most valuable asset for many people is their home, and home equity is oftentimes a nest egg just waiting to be tapped into for convenient cash. If your home’s market value exceeds the amount owed on your mortgage by a significant amount then you may be able to easily borrow against that equity.

Maybe you want to add a room to your house, upgrade the kitchen, or transform the detached garage into an income-producing studio apartment, but you don’t have the money. With a home improvement loan you can use the home equity that’s just sitting there doing nothing as your source of funds.

You don’t necessarily have to spend home equity on a project that will enhance your property, either, because banks offer home equity loans that provide cash you can spend however you please. Need money to start a business, send a child to college, buy a new car, or pay unforeseen medical expenses? That will work, or you can just splurge on something fun like a vacation somewhere. There are some inherent risks, however, so tread carefully.

Second Mortgages & Home Equity Loans

Generally speaking, home equity loans are second mortgages and both terms refer to exactly the same thing. To keep it simple, just remember that the loan you used to buy your home is the first mortgage.  If you are still paying off that first mortgage and take out another loan against the value of your home, that subsequent loan is technically called a second loan. Unless you have paid off your home free and clear, any home equity loan you take out can be considered a second loan.  Lenders use lots of names for their loan products to help market them, and sometimes the jargon can be a little confusing. Home equity loans all share the same collateral in common, though, namely your home. How they are structured and the ways in which you can use them are not the same, however, and the differences will help you determine which one is appropriate for you in your particular situation.

Now is a good time to look at some definitions and characteristics of home equity loans.

Home Equity Loans

  • With a home equity loan, as is the case with most consumer loans, you receive the money you borrow in one lump sum delivered at closing.
  • Home equity loans have fixed rates and are paid off in equal monthly installments. The repayment period depends on what you and your banker agree upon, and repayment schedules can range from one year to 20 years or longer.
  • The amount that you are eligible to borrow will depend upon factors such as your income and credit history, but will normally be limited to no more than 85 percent of the equity in your home.
  • How much equity you have will be determined by subtracting what you owe on the home from its current market value, which is arrived at by doing a professional appraisal.

Home Equity Line of Credit (HELOC)

  • A HELOC is a revolving line of credit, which means it works essentially the way that your credit card does as far as using the money is concerned. The more you borrow, the less credit you have left. Repay what you borrow and your credit limit goes back up again. How much you can borrow on a HELOC is determined by an appraisal and by how much equity you have available.
  • As is the case with a credit card, you only tap into the line of credit when you want to. If you don’t use it then you do not pay interest charges, which only kick in when you borrow against the line of credit. A HELOC is a great tool to use as a financial safety net that is only activated in an emergency, like after a natural disaster strikes your home.
  • Interest on a HELOC loan is variable, so it can fluctuate and may go up, increasing the cost of your loan. Be sure to study the rates and terms of your particular HELOC before you sign on the dotted line. There are lots of different HELOC plans, so you’ll need to do comparison shopping between lenders.
  • There are also various application fees that you may have to pay to initiate the line of credit that can add up to a substantial amount, so you’ll need to crunch those numbers. One major difference between a credit card and a HELOC is that you may be able to deduct the interest paid on your HELOC from your taxes, which can be a nice perk. Check with your tax planner for details.

Major Risk Factors

  • If you miss a payment on one of those cool home equity loan products, the bank will initiate foreclosure proceedings. Within 90 days your home can be on the auction block. Home equity loans carry risks and irresponsible use of them can be disastrous.
  • Your equity is based on market value, for instance, and if the housing market crashes how much your home is worth can shrink dramatically, almost overnight. In that situation the bank may drastically limit your line of credit or demand full repayment of the outstanding loan.
  • You may be unable to refinance your home until you first pay off your home equity loans, or you may find that you cannot sell your home for enough money to pay off your first and second mortgages.
  • When that kind of problem arises it can lead to default, foreclosure, and even bankruptcy. That’s why it is so important to understand the benefits as well as the hazards, and to know how to use home equity loans wisely and prudently, not recklessly.

Smart Borrowing Guidelines

To limit your risk, only use home equity loans when absolutely necessary. Only borrow a small amount of your equity, leaving a sizable cushion to protect you in the event that your house value suddenly plummets. It’s also a good idea to only use home equity loans for projects that will add real value to your house, like repairs or smart, sensible improvements. That way you are reinvesting the money to enhance resale value, which helps to add back to the equity you are draining through borrowing.

Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by any card issuer.

*The content in this article is accurate at the publishing date, and may be subject to changes per the card issuer.

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