You've probably heard of home equity loans, but you might be unclear on what these credit vehicles actually entail. Although the concept of a home equity loan is simple enough to understand, any detailed description of this form of credit requires parallel explanations of often confusing terms. Before you talk to a home equity loan provider, protect yourself by taking the time to learn the basics.
Defining Home Equity Loans
When you take out a home equity loan, you're not directly borrowing against the value of your home. Rather, you're borrowing against the equity that you've built up during your stint as a homeowner. In this case, "equity" is defined as the difference between the assessed value of your home and the amount that you still owe on your mortgage. With each mortgage payment that you make, your equity increases. Depending on your credit rating, most banks and mortgage specialists will allow you to take out loans of up to 85 or 90 percent of your total home equity. If your total equity comes in at $100,000, you could qualify for a loan of $85,000 or $90,000.
Basic Home Equity Loan Structure
These loans are structured fairly simply. Most lenders deliver the principal in a lump sum and demand monthly repayments over a 15-year span. While some lenders offer gimmicks that allow borrowers to defer their repayments for periods of variable length, most require their clients to begin paying back their balances immediately. Unlike mortgages, most home equity loans come with fixed interest rates.
It's important to distinguish classic home equity loans from home equity lines of credit: Whereas the former is a lump-sum loan, the latter is a variable-balance credit facility that allows borrowers to draw equity from their homes over time. Unlike home equity loans that require regular repayments, HELOC balances can remain outstanding and accrue interest for years on end.
How Does Collateral Work?
Before you take out a home equity loan, you must understand the concept of collateral. "Collateral" describes a tangible object with quantifiable value that's used to "secure" certain types of loans, including home equity loans. Once it provides your loan's principal, your home equity lender obtains an equivalent claim to the equity in your home. In practice, this means that your lender can place a lien on your home in the event that you become delinquent on your loan. If your loan goes into default, your lender may be able to repossess or sell your home to cover its loss.
Common Uses for Home Equity Loans
As long as you're willing to repay it, you can use your home equity loan's principal for just about anything. Most homeowners take out home equity loans to finance big-ticket projects that boost the value of their homes. These might include:
- Expansions and refurbishments
- Kitchen or bathroom remodeling
- Bonus room construction
- Landscaping and infrastructure upgrades
Since home equity loans come with relatively low interest rates, they're often used to "roll over" high-interest debt. Depending on the rate that you secure on your home equity loan, you could save thousands of dollars by paying off your high-interest credit card debt with a lower-interest home loan.
Drawbacks, Dangers and Common Mistakes
Home equity loans come with some drawbacks. The most obvious is the threat of foreclosure: If you allow your loan to go into default, you can be virtually certain that your lender will make good on its threat to repossess your home. If you unexpectedly lose your job or home, larger home equity loans can quickly become unmanageable. Additionally, not all home equity loans are alike: Sketchy lenders often gloss over ballooning interest rates and other drawbacks during the loan origination process. It's imperative that you read all of the fine print on your loan documents before signing anything.