Advantages and Disadvantages of a Home Equity Mortgage
Home equity loans, also commonly referred to as second mortgages, can help you turn your real estate assets into cold, hard cash. They come in two forms -- fixed-rate loans and variable lines of credit -- and give banks the security foundation necessary to lend you a large sum of money. While choosing to take out a home equity loan is an immensely personal decision whose advantages and disadvantages can swing widely in either direction -- depending on your finances -- several general pros and cons apply to everyone.
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Advantages: High Financing Potential
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With a home equity mortgage, you have the potential to get a very large, secured loan -- much larger than other traditional forms of financing, such as credit cards. It all depends on the current real estate market and the lender's loan-to-value ratio. Simplistically explained, lenders look at the total value of your home minus the outstanding balance of any existing mortgage then offer you a loan that's a percentage of this. Keep in mind that the higher your loan-to-value ratio -- specifically anything that constitutes 90 percent of your home's value or higher -- the higher your interest rates.
Disadvantages: Foreclosure
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With a home equity mortgage, you're betting the proverbial farm. The lender directly links the value of your home with the value of your loan. If you're unable to make your mortgage payments, the bank can force your home into foreclosure, which essentially means that the bank takes possession of the home if you default on the loan. Thus, taking out a home equity mortgage to help finance riskier endeavors, such as a start-up business plan, may not be the best decision.
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Advantages: Tax Breaks
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The United States' tax system offers up an extremely complex network of rules and regulations. Depending on both your tax bracket and your filing status, you may be able to count your home equity interest payments as tax deductions. This can result in hundreds of dollars of savings, reports the "Kiplinger" financial magazine. This works out much better than other forms of debt, such as traditional credit card debt, as the government doesn't subsidize those interest payments.
Advantages: Lower Interest Rates
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Often, home equity mortgages offer lower interest rates than those found in more liquid forms of financing, such as credit cards. Thus, some home owners may find it advantageous to consolidate their various forms of debt by taking out a home equity loan to pay off their other financing. In this way, not only does the home owner lock into a lower interest rates, but he also experiences a more streamlined, simpler form of financial management since he only has to make a single loan payment.
Disadvantages: Hidden Fees
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As with any major financing project, home equity loans can carry all kinds of hidden fees in the layers of documents and fine print that a home owner must read and sign. These can add significant fees to the total experience, much like the signing and closing fees of a first mortgage. For example, some home equity mortgages penalize home owners for paying off their loan faster than expected. Because this varies by lender, always talk to the financial institution to make sure you understand all of the details, fees and payment structures.
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