Explanation of Home Equity Loans

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A home-equity loan is money borrowed by pledging the equity in the home as collateral. Even if there is an existing mortgage in place, a second mortgage can be obtained as long as there's enough of a difference between how much you owe and how much the home is worth; that difference is known as equity. Because the loan is secured by the home, lenders generally charge lower interest rates for home-equity loans than credit cards or other types of financing.

Equity

  • A home-equity loan cannot be obtained for more than the current equity in the home. For example, if your home is worth $300,000 and the first mortgage has been paid down to $200,000, you have $100,000 of equity in the home. The amount of equity will fluctuate along with the real estate market, which can make it more difficult to get a loan in times of recession because there is less equity in your home.

Uses

  • Home-equity loans can be used to help cover large expenses, such as medical bills or home improvements. They also can be used to consolidate other high-interest loans or credit card debts into one payment at a lower interest rate. Also, students from families with high incomes might not be able to qualify for grants or need-based scholarships, making their parents' home-equity loan the best way to pay the tuition.

Time Frame

  • Home equity loans generally have a shorter term than a home's first mortgage. Most first mortgages are amortized over a 30-year term, and the term of a home-equity loan rarely will be longer than 15 years and can be as short as five.

Lines of Credit

  • A home-equity line of credit (HELOC) gives you a revolving line of credit that can be drawn upon as needed and repaid. It operates in a similar manner to a credit card, but it usually has a lower interest rate and higher limit. The interest rate on a HELOC is usually adjustable and may vary throughout the term of the loan.

Warning

  • If you default on a home-equity loan, the bank can foreclose on your home. This can happen even if the outstanding loan amount is less than the value of your home. If you are able to pay the outstanding amount from another funding source, you will be able to keep your home. Be especially careful when using a home-equity loan to consolidate credit card debt.

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