Home equity loans can be a tricky subject. They’re often called second mortgages because you also secure them with your house. Just like your first mortgage. There are many different reasons why you would venture into the home equity loan world. The primary aim is to be able to fund big milestones in life. (Sending your kid off to college, for example.)

Equity loans come with their own advantages. Since they are secured loans, you can get a much lower interest rate on the loan than unsecured loans such as personal loans without collateral. With favorable loan interest rates, you end up paying a lot less money over the life of your loan.

Furthermore, the interest on a home equity loan is usually tax-deductible — provided the loan is taken to improve your property, build upon it, or buy a new home.

Applying for a home equity loan, more often than not, requires you to have an excellent credit score, good equity in your home, and a good loan-to-value ratio on your property. It’s a great tool for responsible borrowers with a reliable source of income and a good credit report.

The good thing is, you can make extensive home improvements, pay education fees, or resolve any kind of debt including a student loan.

Home equity loans work on the principle that borrowers get a lump-sum payment against collateral. They, then, repay the loan amount with fixed-rate interest over a predetermined loan term.

The lender typically carries out a credit check and orders a home appraisal to determine your loan-to-value ratio and what your home is worth. Basically, your creditworthiness.

One of the main disadvantages of home equity loans is that it involves considerable risk. You could lose your home in case of a delayed or missed repayment. Since your home is used as collateral, if you default on the loan, the lender can foreclose on the property.

Pros and cons of a home equity loan

Let’s list out some key benefits and drawbacks of home equity loans for your convenience:

Pros

It offers an easy source of loan credit.

Good choice for expensive home repairs and debt consolidation.

Lower interest rates than credit cards and other consumer loans.

It could include a tax deduction.

Easy to obtain a loan.

Cons

May lead to a possible spiraling debt or a perpetual cycle of overspending.

Could have a potential risk of home foreclosure.

May have higher fees and closing costs.

Types of home equity loans

When you start to research your loan options, you will find different possibilities to consider. And picking the best one for you and your needs is a decision that must be well thought of.

There are two types of home equity loans: closed-end loans and lines of credit. Each one has its own set rules and serves different purposes.

1. The loan:

A home equity loan provides you with a one-time chunk of money, which you will have to pay in a determined amount of time, with a fixed interest rate. Monthly payments will remain the same over your payback period. It is called a closed term loan because once you get the money, you can’t borrow any more.

Ideal scenarios for this type of home equity loan is knowing exactly how much you need and when you need it. For example: if you’re planning a bathroom renovation for $10,000 and your daughter’s sweet sixteen gift is a car, say $5,000. You know you need $15,000 and you also know both payments are due in full next month. Since you have no major future expenses and you’re not planning to borrow again, then this is definitely your best choice.

Do keep in mind that there are home equity loan closing costs and fees to factor in too. Although these may vary from one lender to another, they typically range from 2% to 5% of the loan amount. These may include fees for a property appraisal, application fees, and your attorney’s fees.

However, some banks offering good home equity loans may pick up a share or waive them altogether. Do reach out to your financial institutions to find out.

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2. The line of credit:

A home equity line of credit (HELOC) is a flexible type of loan. The lender will set an amount and during a determined period of time, you will be able to use the money. The difference is, that during that time, you can withdraw money as you need it. It’s not just a lump sum. As you pay off your principal debt, your credit revolves and you can actually use it again. It’s similar to a credit card. If your line of credit is $10,000 you borrowed $8,000 but you paid off $4,000. You now have $6,000 available to borrow again.

These types of loans don’t have fixed interest rates and they may vary throughout the life of the loan. These types of loans are best used when you need the money over different time spans. Like paying for your kid’s semester or a home renovation project that will last two years. This is the type of loan you will need. It’s more flexible and you can use the money when you need it.

A HELOC has a draw period of five to 10 years. Then comes a repayment period of 10 to 20 years.

When you apply for a HELOC, it does impact your credit score but to a small extent. However, if you default on your monthly payments, there are considerable negative repercussions.

There are many advantages to a home equity line of credit; they’re probably your lowest interest rate. Be sure to speak to a loan officer and be specific about your needs so you pick the right choice for you.

Key takeaways

A home equity loan allows homeowners to borrow against their home equity.

Home equity loan amount is calculated on the basis of the difference between your home’s market value and the mortgage balance.

Home equity loans are either fixed-rate loans or home equity lines of credit aka HELOCs.

While a fixed-rate home equity loan offers a lump-sum loan amount, HELOC offers a revolving line of credit which the borrower can use as and when required.

Before you apply for a home equity loan, do compare terms and interest rates that lenders offer.

Don’t hesitate to reach out to your local credit unions offering good interest rates.

Know how much you need to borrow and what to use the money for.

Use a loan calculator to estimate your loan payments. Run the numbers with your bank. Make sure they are payable with your other financial obligations.

Read more: Home Equity Line of Credit vs Home Equity Loan