Home Equity Loans

Home equity loans, also known as a second mortgage, a term loan, or a closed-end loan, are mortgage plans that borrow against the equity in your home, which is the market value of your home less any outstanding mortgages. In essence, this is putting up your ownership in the house as collateral, which will ultimately put the house into foreclosure should you default. This second loan is in addition to your original loan and is repaid over a fixed term with steady monthly payments.

Uses: mostly, these types of loans are used to increase the value of the home by making home improvements or by somehow improving the homeowner's financial situation. Smart ways to use the money would be to consolidate debts, finance a business, or use to fund renovations or additions to the house and property. These type of improvements generally push the market value of the house up above that of the loan amount, and so effectively increase the homeowner's equity.

Advantages of a home equity loan:

• Tax deductible interest. To learn exactly how much money you will save, you will need to visit your tax advisor, but as a general guide, at the end of the year the interest paid will be subtracted from your taxable income, up to $100,000.
• A lower interest rate. Home equity loans will have lower interest rates than other types of high-interest borrowing such as credit cards, but will often be higher in points and fees than other loan programs because lenders consider them high-risk.
• A cash-out home equity loan, where you receive part of the loan amount in one lump sum upon closing, can help finance a business, college education, or much needed repairs.

Disadvantages:

• Reduction of equity. The risk of foreclosure is a dangerous one. If you decide that a home equity loan is best for you, then be sure to choose the plan with a a short loan term. The average second mortgage is 5-15 years, so if you can stay on the low end of the spectrum, you will save thousands of dollars in interest payments.
• Hidden costs, fees, high rates, and penalties. Please be careful when considering any mortgage plan. Get a Good Faith Estimate (GFE) and make sure your interest rate and points are within reason--get your rate lock in writing and have your loan officer or broker sign it. For tips on what to include in your agreement, visit our page on Mortgage Brokers. Remember that mortgage lenders are in the business to make money, so don't let such things as pre-payment penalties slip past you. Be aware of all fees and closing costs.

If you do not know beforehand how much money you will need for a renovation project, consider going with a home equity line of credit (HELOC). This loan is a revolving line of credit that lets you draw out funds repeatedly over time, up to the previously-set limit. One distinct advantage of a HELOC is that you only pay interest only on the amount you draw out, and can repay it in steps. This is optimal if you have a remodeling project that will be completed in stages, or perhaps college tuition to pay for. For more information, see our section on Refinancing.