The Home-Equity Loan: What It Is And How It Works

A home-equity loan, also known as a second mortgage, lets homeowners borrow money by leveraging the equity in their homes. Home-equity loans exploded in popularity in 1996 as they provided a way for consumers to somewhat circumvent that year’s tax changes, which eliminated deductions for the interest on most consumer purchases. With a home-equity loan, homeowners can borrow up to $100,000 and still deduct all of the interest when they file their tax returns. Here we go over how these loans work and how they may pose both benefits and pitfalls. 

 Two Types of Home-Equity Loans :

 Home equity loans come in two varieties – fixed-rate loans and lines of credit – and both types are available with terms that generally range from five to 15 years. Another similarity is that both types of loans must be repaid in full if the home on which they are borrowed is sold. 

Fixed-Rate Loans:

 Fixed-rate loan provide a single, lump-sum payment to the borrower, which is repaid over a set period of time at an agreed-upon interest rate. The payment and interest rate remain the same over the lifetime of the loan. 

Home-Equity Line of Credit

A home-equity line of credit (HELOC) is a variable-rate loan that works much like a credit card and, in fact, sometimes comes with one. Borrowers are pre-approved for a certain spending limit and can withdraw money when they need it via a credit card or special checks. Monthly payments vary based on the amount of money borrowed and the current interest rate. Like fixed-rate loans, the HELOC has a set term. When the end of the term is reached, the outstanding loan amount must be repaid in full.  Benefits for Consumers Home-equity loans provide an easy source of cash. The interest rate on a home-equity loan – although higher than that of a first mortgage – is much lower than on credit cards and other consumer loans. As such, the number-one reason consumers borrow against the value of their homes via a fixed-rate home equity loan is to pay off credit card balances (according to bankrate.com). Interest paid on a home-equity loan is also tax deductible, as we noted earlier. So, by consolidating debt with the home-equity loan, consumers get a single payment, a lower interest rate and tax benefits. 

Benefits for Lenders Home-equity loans are a dream comes true for a lender, who, after earning interest and fees on the borrower’s initial mortgage, earns even more interest and fees. If the borrower defaults, the lender gets to keep all the money earned on the initial mortgage and all the money earned on the home-equity loan; plus the lender gets to repossess the property, sell it again and restart the cycle with the next borrower. From a business-model perspective, it’s tough to think of a more attractive arrangement. The

Right Way

to Use a Home-Equity Loan

Home-equity loans can be valuable tools for responsible borrowers. If you have a steady, reliable source of income and know that you will be able to repay the loan, its low interest rate and tax deductibility of paid interest makes it a sensible alternative. Fixed-rate home-equity loans can help cover the cost of a single, large purchase, such a new roof on your home or an unexpected medical bill. And the HELOC provides a convenient way to cover short-term, recurring costs, such as the quarterly tuition for a four-year degree at a college. Recognizing PitfallsThe main pitfall associated with home-equity loans is that they sometimes seem to be an easy solution for a borrower who may have fallen into a perpetual cycle of spending, borrowing, spending and sinking deeper into debt. Unfortunately, this scenario is so common the lenders have a term for it: reloading, which is basically the habit of taking a loan in order to pay off existing debt and free up additional credit, which the borrower then uses to make additional purchases.  Reloading leads to a spiraling cycle of debt that often convinces borrowers to turn to home-equity loans offering an amount worth 125% of the equity in the borrower’s house. This type of loan often comes with higher fees because, as the borrower has taken out more money than the house is worth, the loan is not secured by collateral. Furthermore, the interest paid on the portion of the loan that is above the value of the home is not tax deductible. If you are contemplating a loan that is worth more than your home, it might be time for a reality check. Were you unable to live within your means when you owed only 100% of the value of your home? If so, it will likely be unrealistic to expect that you’ll be better off when you increase your debt by 25%, plus interest and fees. This could become a slippery slope to bankruptcy. Another pitfall may arise when homeowners take out a home-equity loan to finance home improvements. While remodeling the kitchen or bathroom generally adds value to a house, improvements such as a swimming pool may be worth more in the eyes of the homeowner than the market determining the resale value. If you’re going into debt to make cosmetic changes to your house, try to determine whether the changes add enough value to cover their costs.  Paying for a child’s college education is another popular reason for taking out home-equity loans. If, however, the borrowers are nearing retirement, they do need to determine how the loan may affect their ability to accomplish their goals. It may be wise for near-retirement borrowers to seek out other options with their children. Should You Tap the Equity in Your Home?

Food, clothing and shelter are life’s basic necessities, but only shelter can be leveraged for cash. Despite the risk involved, it is easy to be tempted into using home equity to splurge on expensive luxuries. To avoid the pitfalls of reloading, conduct a careful review of your financial situation before you borrow against your home. Make sure that you understand the terms of the loan and have the means to make the payments without compromising other bills and comfortably repay the debt on or before its due date.

Home Equity Line of Credit vs. Fixed Rate

Home equity line of credit (HELOC) works like a credit line. You will receive special “equity” checks that can be used to advance yourself a loan up to your approved available balance. Simply write the loan amount you need.  Some lenders will also provide credit card-like access to your HELOC line account. You can use this like a credit card and all transactions will be posted to your home equity line account.  One word of caution. Even though your account is protected against fraudulent use, the last thing you need is to have your home exposed to potential fraud in the event you lose your card or someone obtains access to your card numbers.  It’s recommended that you use the special equity checks to access your HELOC account. Keep and protect them in your home. Never carry these checks with you.  

When you need to access your home equity line of credit account, write the loan amount you need with your equity check and deposit it in your bank checking or money account. Then use the debit or check card that came with your money account to charge transactions at retail and other establishments.  How Are HELOC Rates Determined? Home equity line rates are variable and indexed to the PRIME RATE or some other rate index. This means your rate can increase or decrease whenever the PRIME RATE changes. The rate (APR) is calculated by taking a margin (percentage) and adding it to the PRIME RATE.  Whenever the PRIME RATE increases, your monthly payment due will likewise increase. Whenever the PRIME RATE decreases, your monthly payment due will likewise decrease.  The interest (APR) that will be charged to your home equity line of credit account will be only on the amount you actually use, not on the total amount of your credit line.  

If the lending institution uses an index other than the “PRIME RATE,” request to view historical changes for the index rate being used. Compare this trend against the historical trends for the “PRIME RATE” to note frequency changes in APR and how high the interest rate has climbed.  All HELOC accounts must list the rate cap for the account. This cap may vary by state.  What Are HELOC Payment Terms? Minimum payment terms for home equity lines of credit may include one of the following plans:  Interest only plus any penalty-related fees Percentage of the principal plus interest and any penalty-related fees  

Keep in mind that any principal repayment will not reduce your balance to zero at the time your HELOC account closes. You must pay an additional amount to reduce your balance to zero over a repayment term.  These repayment terms may vary by lender. You should be able to pay down your home equity line account at any time without prepayment penalties. If not, find another lender.  With most programs, you can advance yourself a loan as many times as your like, as long as the advance does not exceed your approved available balance:  The advance feature is usually available for 5-10 years at most lending institutions, at which time you may renew your home equity line option, pay off the loan amount, or convert your home equity line balance over to a fixed rate equity loan amortized at repayment terms set by the lender.  

Again, these terms may differ by lender. Some lenders do not offer a renewable feature or allow conversion of the home equity line balance over to fixed-rate amortized loan.  Be sure to review the terms before making your final decision.  Home Equity Loans  How Do Home Equity Loans Work? The home equity loan is a fixed rate loan. The money is advanced to you when you close your equity loan. This advance is a one-time loan, with no further advances made on your account.  

How Are Home Equity Loan Rates Determined? Home equity loan rates are fixed and set by the bank. The rate will not go up or down during the repayment period of the loan.  What Are Home Equity Loan Payment Terms? Your monthly payments are fixed. The amount and number of payments depend on the repayment terms of your loan. Lenders offer a range of repayment terms, generally from 5-20 years.  You may pay off your home equity loan at any time, but you should check the lender’s prepayment terms. Some lenders will charge a prepayment penalty under certain circumstances.  How Much Can You Borrow with HELOC or a Home Equity Loan?

The approved available home equity line or home equity loan balance is secured by the equity in your home. The total amount approved depends on your LTV position, which is determined by taking a percentage of the appraised value of your home and subtracting the balance owed on the existing mortgage.