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Are you wondering how you are going to pay for the leaky roof � or your child's braces? A home equity loan could be the answer.
So you've decided you are finally going to update your kitchen and make it bigger. Or your car died, and you need a new one. Whatever the reason you need money, whether it's for home improvements, medical bills, to consolidate your credit card debt, or pay for your child's college tuition, a home equity loan or line of credit could be a good option.
When you obtain a home equity loan, you are borrowing money by using equity in your home as collateral. Equity is the difference between the appraised value of your property and the amount you owe on your mortgage. A home equity loan, also known as a second mortgage, provides you with a fixed amount of money, repayable over a fixed period of time. A second mortgage can be a great alternative to unsecured loans. For instance, the interest rate on a home equity loan is usually lower than the rates on revolving or installment debts such as credit cards or car loans. Another major advantage is the interest you pay on a home equity loan is tax deductible on loan amounts up to $100,000.
Interest rates on second mortgages are typically fixed, although there are variable rate programs available. The term on these types of loans can vary from 5 to 25 years. The process of borrowing for a second mortgage works similarly to a first mortgage. The lender will have to qualify you by looking at your liabilities, assets, and creditworthiness, as well as appraising your home. However, closing costs should be much lower than closing on a first mortgage. See the U.S. Federal Trade Commission brochure on shopping for a home equity loan.
Typically, a lender will limit the total amount you can borrow based on the market value of your home, which is determined by the appraisal. The limit usually ranges from 70% to 80% of the equity in your home, although there are some loan programs that will allow you to exceed these limits.
To determine how much you can borrow against the equity in your home, follow this example:Appraised Value of home: $100,000
Typical home equity loan maximum: 75%Amount of equity available: $100,000 x .75 = $75,000
Minus outstanding first mortgage: $50,000Maximum Loan Amount: $25,000
In this example, based on the amount of equity in your home, you would be able to borrow $25,000.
So, you know you need to borrow money, but are unsure how much you need. Then, a home equity line of credit may be a better alternative. This kind of loan is also securitized by your home, but it works more like revolving credit. Based on the amount of equity you have, you will be approved for a certain amount of credit. So, when you need to access the money, you can write a check for the amount you need which will be drawn against your line of credit. Home Equity Lines of Credit usually have an access period where you can use and re-use your available credit line. Some lenders will allow you to use a debit card or even attach the credit line to your regular checking account.
The interest rate on a home equity line is often adjustable and is based on an index, such as the prime rate. Your interest rate adjusts as the prime rate changes. However, these loans do have a rate cap, which the interest rate can never exceed. Your payments are based only on the amount you have actually drawn from the credit line. So, for instance, if your credit line is $15,000, but you have only used $5,000, your payment will be based on the $5,000.
For many home equity line programs, your minimum payments are interest only for a specified term. You do not have to pay the principal until the loan is due. The term for these types of loans vary by lender, but usually range from 5 to 15 years. Normally, you can pay the loan back as quickly as you want, although some lenders charge a pre-payment penalty during the first three to five years. For more information on home equity lines of credit, see the U.S. Federal Reserve Board publication When Your Home Is on the Line: What You Should Know About Home Equity Lines of Credit.
A benefit of a home equity line of credit is that the approval process is less stringent than a home equity loan. However, a lender will still look at your creditworthiness and the market value of your home. A home equity line of credit often allows for a higher percentage of the appraised value to determine the maximum amount of the credit line. Also, closing costs are usually lower than a home equity loan. In fact, there is so much competition that many lenders offer home equity lines of credit with no closing costs. Beware that these loans may have a higher initial interest rate, so compare the APR carefully.
If you know exactly how much money you need to borrow, a home equity loan may be the right alternative. The term on this type of loan is usually longer and, therefore, the payments are lower.
On the other hand, if you are not sure how much you are going to need and want the flexibility of only paying for the amount you draw, then you should opt for a home equity line of credit. The following chart will allow you to compare both options:
|Home Equity Loan||Home Equity Line|
|Typical Term||5 to 25 years||10 to 15 years|
|Typical Rate Type||Fixed, but can be adjustable||Adjustable|
|Verification||More stringent than home equity line||Less stringent that home equity loan|
|Closing costs||Higher than home equity line; lower than first mortgage||Lower than home equity loan|
|Loan Amount||Fixed||Credit line maximum|
Some lenders offer home equity products that allow you to borrow up to 125% of the value of the property. If you choose this type of loan product, the interest on the amount you borrow that exceeds 100% of your property value is not tax deductible. Additionally, you should remember that you are putting your house on the line. If you borrow an amount that you can't afford, and find that you can't make your payments, you could lose your house to the lender, especially if you use the loan to pay off your credit cards, and then start using the cards again and rack up more debt. For information on avoiding home equity loan scams, see the State of Missouri's publication about home equity loan fraud or the National Consumer Law Center's article about predatory home mortgage loans.
Home equity loans and lines can be a great alternative, if used wisely. Understanding the difference between home equity loans and lines will allow you to determine which one is best for your situation.
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