Financial Learning Center
- Reasons to Tap Your Equity
- Understanding Home Equity Loans
- The Home Equity Loan Process
- Home Equity Loans and Taxes
Home equity loans, sometimes referred to as second mortgages, involve borrowing money and making principal and interest payments over a specified period of time. The debt is secured by your home. Here are some features of home equity loans:
- Your repayment period can vary. Home equity loans often have a repayment period of 15 years, although it could be as short as five years or as long as 30 years.
- You can generally borrow up to 75% to 80% of the current appraised value of your home; this result is then reduced by your outstanding mortgage balance.
SUGGESTION: You may find a lender who is willing to lend you more than 75% to 80% of the current appraised value of your home, minus the outstanding mortgage balance, especially if you can prove that you will be making improvements to the home that will increase its value.
- Interest rates are generally higher than on first mortgage loans.
- Lenders usually offer a choice between fixed-rate and adjustable-rate loans.
Home Equity Line of Credit
Another way to tap the equity in your home is with a home equity line of credit (HELOC). Instead of borrowing a fixed amount of money at one time, you can establish a line of credit against the equity in your home and draw on the money as you need it. The lender will set a limit on the total amount you can borrow and will issue you checks. It is almost like a checking account, except you have to pay back the money! Following are some features of a home equity credit line:
- The maximum credit line is typically limited to between 75% and 80% (but can be more depending on the lender) of the current appraised value of your home; the credit line is then reduced by your outstanding mortgage balance.
- Interest is usually a variable or adjustable rate, which can vary as often as monthly.
IMPORTANT NOTE: With most lines of credit as well as some equity loans, you will receive a variable interest rate. When evaluating these loans, make sure that you consider the worst possible scenario. In other words, be sure that you can handle higher monthly payments during a time of rising interest rates. Find out from your lender what the ceiling is. This is the maximum interest rate they can charge on your home-equity loan.
- You only pay interest on what you borrow, not on the entire line of credit.
- Lenders typically require a minimum monthly payment on any outstanding loan amount.
- Most home equity credit lines are divided into two periods—a draw period and a payback period. A draw period—the period of time you are able to draw from the credit line—typically lasts from 10 to 15 years. The payback period is the period of time you have to pay back the outstanding balance. It usually ranges from 10 to 20 years.
What Makes Home Equity Loans So Attractive?
Home equity loans or credit lines have become increasingly popular. Many lenders promote these loans in various advertising media. Indeed, home equity loans and lines do offer the following advantages to borrowers:
- Low cost. The fees associated with these loans are very reasonable. You can probably figure on costs ranging up from about $800, depending on the amount of points involved. You may want to consider paying a point or more to get a lower interest rate (see the section "Understanding 'Points'" in When Does It Make Financial Sense to Refinance?). Keep in mind that many lenders allow you to add the costs to the loan, so you don't have to come up with too much cash out-of-pocket.
- Tax-deductible interest. Generally, interest on a home equity loan or credit line is a tax-deductible expense if the loan is used to “buy, build or substantially improve” the home that secures the loan. There are limits; see the section What Can You Deduct on Your Tax Return?
- Easy to obtain. Your loan could be approved in a relatively short time. You always have three business days to back out of the loan after it has been approved.
Be aware that some lenders may check your credit record periodically to see if you've been responsible with your loans. They have the right to freeze or reduce your borrowing rights if they don't like what they see on your credit report. Lenders also have the right to get a reappraisal on your home to make sure the equity in the home remains intact.
IMPORTANT NOTE: Many home equity loans and lines of credit offer low introductory "teaser" rates. These may have strings attached to them, such as annual fees and other hidden costs and restrictions. Make sure you find out all of the details first.
Loan or Line of Credit?
At first glance, it seems that a line of credit is the best way to go. It offers you flexibility; you don't have to saddle yourself with debt that you may not have a use for right away. You can draw down as you need the money and pay back accordingly. But avoid the temptation to use your home equity line as a source of ready cash for unnecessary spending. If you can't control your spending, don't take out a home equity line.
Only you know yourself and your habits. We can't stress enough that it is dangerous to frivolously tap the equity in your home. After all, your home is probably the most valuable asset you own.
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