An Introduction to Home Equity Loans

You have probably heard about home equity loans or second mortgages before. Before the housing market crash, second and even third mortgages were common throughout the United States. Lenders have grown more cautious about handing out home equity loans in recent years, but they remain a potential source of low-interest funds for many homeowners in stable financial positions.

If you have had your mortgage for a number of years and have steady financial ground under your feet, home equity credit is a possibility. Before you jump in, research what type of loan would work best for you and what terms you can expect. Here are some facts to get you started.

The Home Equity Deal

A home equity loan is a secondary loan you can take out using your house as collateral. Yes, your first mortgage also uses your house as collateral. But as you pay off your first mortgage, its claim on your house is lessened, and equity – the stored value of your house – is built up. Once equity is built up high enough, you can use that portion of restored value to create an additional loan. Lenders typically provide home equity loans only to owners that have been making payments on their first loan for at least several years.

There is a simple formula that shows how much you could borrow on your equity. Find or estimate the current market value of your house, then subtract 20% of that value. Next, subtract all the unpaid principal of your first mortgage. The resulting value is the amount a bank would be willing to lend. Lenders prefer to consider only 80% to 85% of your home’s value to make room for market shifts other risks.

Would You Use It?

While having an extra pocketful of cash sounds nice, you should only attempt to acquire a home equity loan if you really need the money. Several traditional uses for home equity cash exist, such as education, home improvement projects (which have the additional bonus of building more equity), and investments. You may notice similar features between these options: They all have long-term value, and they all have the potential to create more wealth for the borrower. Use second mortgage money to fund these decision can be a wise financial move. It can also help consolidate other debt under a better interest rate or pay for serious emergencies. Using the money for a vacation or shiny TV is not good debt management and can lead to dangerous “reloading,” or piling one debt over another to cover ongoing costs.

Key Considerations

Home Risk: A home equity loan uses your house as collateral just like the first mortgage, which means it can lead to foreclosure and possibly the loss of your home if your debt burden becomes too heavy.

Rate Comparison: Second mortgages have very flexible rate structures compared to primary mortgages. Compare interest rates between loans and watch for potential rate shifts. If you choose an adjustable rate structure, the lender could increase your original rate every several years within specific limits.If you choose a fixed rate, the interest rate will remain unchanged for the life of the loan.

Term Features: The longer the term of the second loan, the more interest you will pay. Second mortgages typically last only half as long (10 to 15 years on average) as primary mortgages, but if you can arrange a term below 10 years, do it to save on interest. Be wary of odd structures like balloon mortgages, which require a vast lump sum payment after several years.

More On the Home Equity Loan Process:

FTC: Home Equity Loans: Buyers Beware!

FTC: Home Equity Credit Lines

Home Equity Loan Information: Tour by FAQs

Investopedia: Home Equity Loans: What You Need to Know

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