Home equity loans allow a homeowner to borrow money by pledging the house as collateral. Borrowers who want to borrow a relatively large amount of money or who don’t have good credit often find the home equity loan to be attractive.
Lenders may be more liberal because they view home equity loans as relatively safe. You can’t disappear with your house or hide it if you default on your loan, so the lender has a good chance of collecting the collateral. Also, you are likely to make your payments a priority if your home is on the line.
Getting one’s hands on an extra pile of cash has seldom been easier for homeowners than it is today, thanks to the recent flood of home equity lending offers.
The traditional home equity loan works like a traditional second mortgage. It is a loan that allows you to borrow money against your home’s equity (usually the estimated value of the house minus the amount you still owe. Typically you can borrow 80-90% of your equity amount). You borrow for a set number of years and the loan is usually offered at a fixed rate. You repay little by little every month for a preset number of years.
Your other option is a home equity line of credit, which is sometimes referred to as a HELOC. This type of loan works a lot like a credit card. A lender will approve you for credit up to a certain amount. You don’t have to use that money all at once or ever, but it is there if you need it. Let’s say you have a $40,000 line of credit, but you only use $19,000 to pay off old credit card bills. You’ll still be entitled to borrow the remaining $21,000 any time you want. As you repay what you owe, the amount available to borrow increases.
Home equity lines of credit are usually offered with variable interest rates. The rate will be tied to the prime rate-the rate the best corporate customers receive-or some other index. Lenders will often generate business by offering teaser rates-a ridiculously low rate that may vanish in six months. Make sure that you know what will happen to the interest rate after the introductory offer expires.
Both traditional and line of credit loans use a borrower’s house as collateral, with lenders in either case assessing the property to determine how much they are willing to extend. The amount is determined by taking the assessed value and multiplying by a percentage figure, known as the loan-to-value ratio. Traditionally as high as 80%, that maximum ratio climbed to just over 90% in the late 1990’s.
For example, a lender evaluating a $100,000 house with $40,000 still outstanding on the first mortgage would multiply its value by 90%. The company would then take the $90,000 result, subtract the outstanding debt, and allow the borrower access to as much as $50,000 in credit.
Your home is the collateral to guarantee that you will repay the loan. If you are unable to make the home equity loan payments, you can lose your house when the lender exercises the right to foreclose on the property and sell it at public auction.
Find out a comparison on Home equity loan vs Rate and term, Cash-out refinancing.