How Home Equity Loans Work
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Many people begin to wonder how home equity loans work when money gets tight. Major projects like remodeling or renovating a house, paying for college tuition, purchasing a second residence or consolidating high interest debts have attracted thousands of homeowners to borrow money against the investment placed in their current house. During the past twenty years, these loans have risen in popularity so much that people have even used them for purchasing computer equipment or paying for extravagant vacations. With rising property values and extra tax incentives, more and more people each year seek out how home equity loans work for them.
The key to how home equity loans work begins with equity itself. Buying a house is an investment. Individuals and families purchase property with the hope that it will increase in value and enhance their net worth. Equity is the difference between the value of the property and the amount still owed on that property. The value may not necessarily be the amount paid for the property. More than likely, the value has risen or fallen since the original purchase was made. If it has risen significantly, the equity available may be larger than the original price, even if money is still owed on the property. The longer a homeowner has lived in a certain house, the greater the investment will grow as well.
The basic premise of how home equity loans work includes two types of financing. A home equity loan is basically a second mortgage. It allows a homeowner to borrow large amounts of money using his/her house as collateral. Individuals with poor credit are able to borrow funds fairly easily since the security provided in the house is so stable. Second mortgages are taken out for a specific amount of money. Although interest rates are usually higher than those of first mortgages, the interest of funds up to $100,000 is tax-deductible. Lenders schedule repayments over a fixed period of time, which is considerably shorter than the original mortgage - usually between five and fifteen years, depending on the credit score of the borrower. Prime borrowers can often negotiate for a longer period to repay the funds than subprime borrowers with lower credit scores.
The second type of financing is a home equity line of credit (HELOC). Similar to how home equity loans work, HELOC uses the homeowner's house for collateral, but the similarities end there. The line of credit works similar to a credit card with a pre-determined limit on how much an individual can borrow within a specified amount of time determined by the lender. The credit limit is normally a percentage of the equity that currently exists in the property. Homeowners can draw on that credit using a special card, checks, or electronic transfer. Once the limit is met, the individual cannot borrow more without paying off the original debt. Lines of credit also use a variable interest rate instead of a fixed rate. Some lenders will place a cap on the interest rate during the term of the agreement or will allow borrowers to convert to a fixed rate later in the process. HELOC is an easy way to get funds when the full amount is not known at the beginning of the process or for short-term borrowing needs. With both types of financing, extra closing costs and processing fees may increase the amount of borrowed funds; however, some lenders will waive these extra charges.
Reverse mortgages are another facet of property refinancing. Fewer people qualify for this type of loan. Homeowners must completely own their properties and meet certain age requirements. Lenders will allow customers to borrow up to a percentage of their property value. The older the homeowner, the more he/she can borrow. As long as the borrower lives in the home, the funds do not needs to be repaid, but payment in full is due if the owner sells or dies - in which the inheritors of the property will be responsible. Interest accrues against the value of the property, but like the other plans, is tax deductible.
Home equity loans may seem like a dream to individuals needing money, but homeowners must use caution. Lenders approve financing so freely, because they know how home equity loans work. The biggest risk is that the homeowner loses the property if he/she defaults on the payments. For the lender, the risk is minimal. The institution repossess a house and sells is to replace funds that were lost. The risk is higher for young homeowners who don't have solid job security or older property owners who are near retirement and can't afford to lose their assets. Consumers must become aware of how home equity loans work as well. Drawn in by really low monthly payments, borrowers may ignore a balloon payment, a large installment due at the end of a term. Interest rates may also not be calculated at the beginning and come due later. Some lenders charge large fees or penalties for prepayments. With all financial transactions, be aware of scams. Ask an attorney to review paperwork before signing. "Trust in the LORD with all thine heart and lean not on thine own understanding. In all thy ways, acknowledge him, and he shall direct thy paths" (Proverbs 3:5-6).
As with all financial negotiations, know how home equity loans work. Beware of the pitfalls as well as the advantages. Always read the fine print of any contract. The Consumer Credit Protect Act enacted in 1968 requires lenders to disclose all payment terms, interest rates and fees at the beginning of the agreement. Consumers have three days to cancel a contract without penalty. Research the various lending companies and plan a budget well ahead of time. It is easy to be tempted to borrow more than needed. "Watch and pray, lest ye enter not into temptation" (Mark 14:38). Only request what can definitely be paid back.
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