Home Equity Loans
Do you want to renovate your house, finance education of some family member, need funds for acquiring another home, or consolidation of costly loans? Here is a solution named “Home Equity Loan” and abbreviated as HEL. In this loan homeowner’s equity in his house is pledged as collateral against the borrowing that owner needs for some of life’s major expenditures. These loans are also known as second mortgage or simply “equity loans”. They got popularity in 1996 due to their hidden tax benefit.
The amount of HEL is dependent upon the current market price of house minus owner’s home equity in that particular house. Home equity derives its value from the difference between fair market value/worth of ownership in real property built over time and any outstanding balance of mortgage payments. Thick home equity that is a positive symbol for lender has direct relationship with mortgage payments made by the homeowner (borrower) plus appreciation in the market prices of real estate.
Types of Home Equity Loans
There are two variants of home equity loans. Tenure ranges from 5-15 years and if the home against which loan is issued is sold the remaining loan amount must be repaid fully for both kind of loans.
1) Fixed rate loans: A single lump sum amount is provided to the borrower that is repaid at fixed intervals with predetermined fixed interest rate over a specified period of time. During the lifetime of loan the principal and interest rates remain fixed.
2) Home Equity Lines of Credit (HELOC): It is a variable rate loan in which borrowers are assigned a certain limit. When consumer needs money he can withdraw money less than or up-to the limit assigned to him. In this case monthly principal and interest payments vary according to the amount spent by the borrower during the month. At the end of tenure the outstanding loan balance must be repaid.
Benefits of Home Equity Loans to Borrowers
A small number of reasons for home equity loan to be attractive from borrower’s perspective are:
- They are comparatively cheap with lower interest rates ( undoubtedly these interest rates are higher than first mortgage but still quite lower as compared to credit cards and other traditional loans)
- Tax deduction is another salient benefit. For the loans collateralized by home, tax payers have the right to assert tax deduction on interest payments
- It enables the consumers with bad credit to qualify for the loan easily
- Such loans supply borrowers huge amount of money
Benefits of Home Equity Loans to lenders
From lender’s perspective home equity loans are extremely rewarding. After accumulating money though interest and fee on consumer’s first mortgage, he carries on earning more and more interest and fees. In case of default funds earned on first and second mortgage goes to lender, in addition to that he has the right to liquidate the collateral and can reproduce the whole cycle again for next customer.
How to Use a Home Equity Loan
It’s a valuable source of financing for conscientious borrowers. Those having sufficient, smooth and consistent sources of cash inflows for scheduled repayment can exploit its trivial interest rates and tax benefit. Fixed rate home equity loans assist some major purchases in life that requires long term financing whereas HELOC is a suitable source of short term financing such as quarterly college fees.
Downside of Home Equity Loan
There are certain drawbacks of home equity loans that a borrower must know.
A borrower may sink deeper and deeper into the debt. They become habitual of borrowing, spending, again borrowing and perpetual cycle starts. This cycle also known as reloading is very common in which borrower becomes habitual of taking loans to pay other outstanding loans and make new purchases.
Another pitfall of such loans is when cost exceeds the benefit. Sometimes loans taken for home renovation don’t add to the market value of the property as compared to money spent on it and the borrower of home equity loan becomes unable to cover his cost and repay the loan.