A Home Equity loan is a second mortgage that is secured by the equity in your home. It generally comes in one of two forms. One is the Home Equity Line of Credit, or HELOC, which works much like a credit card and allows you to draw money against your equity whenever you need it. The other form of second mortgage is the home equity loan, or HEL, which gives you the proceeds of the loan in a lump sum. Unlike the variable-rate HELOC, this loan's interest rate is fixed and has a set repayment schedule. The term of a home equity loan is usually limited to no more than 20 years, and total loan-to-value levels (first and second mortgages combined together) are generally 80% or less.
Home equity loans can have many positives. To begin with, you have quick access to cash at a favorable interest rate. Lending institutions generally offer home equities at competitive rates, depending on your credit history and the prevailing interest rate climate. And your loan payment is at least partially offset by the fact that the interest paid on second mortgages is almost always tax deductible. In addition, as long as homes continue to appreciate in value, the equity automatically helps to replenish itself even as you pay back the loan.
Furthermore, if you were to compare the interest rate of a home equity loan with that of a credit card or standard personal consumer loan, you’d find the home equity rates to be considerably lower. Rates on those funds are generally in the double-digit range, and can be laden with service charges and hidden fees. A home equity loan is relatively inexpensive to obtain, and the money can be used for virtually any purpose that you’d like: home improvements, college tuition, debt consolidation, a new car or even a vacation.
There are a few drawbacks that must also be considered, however. Many homeowners do prefer the fact that the home equity loan comes with a fixed rate; however, that rate is almost always higher than that of a regular 30-year fixed-rate first mortgage because the loan is in the second lien position. This makes the loan somewhat riskier for the lender because, in the event that home values fall and the property is foreclosed upon, they might not be able to recoup all of their investment. This higher rate is often somewhat exacerbated by the fact that the term of the home equity is only 20 years, thus creating a somewhat higher monthly payment than might be expected. This can be offset to some degree by the fact that home equities are generally much smaller loans to begin with.
The bottom line with home equity loans, as with all financial products, is to be mindful of your own personal bottom line. Equity in your home can seem like money growing on trees, but be careful how much you pick. Compare loans and lenders, take only what you need, and make sure that the monthly payment is comfortably within your budget.