Guide to Home Equity Loans
URL:
http://www.mortgageloan.com/home-equity-loans/guide/
Author:
Catherine Brock
Published: November 21, 2007
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Guide to Home Equity Loans
http://www.mortgageloan.com/home-equity-loans/guide/
Introduction to Home Equity Loans
What's home equity?
You've heard people talk about home equity in knowing voices. And you've probably seen it mentioned
in the colorful ads spilling out of your Sunday paper. But what exactly is it? It's like a
riddle…something you can't see, touch, or smell.
Home equity is the value of your home that exceeds the balance on your mortgage. In plain English, if
your home is worth $200,000, and you have a mortgage balance of $150,000, your home equity is
valued at $50,000. If your home is worth $200,000, and you've paid off your mortgage in full, your
home equity is $200,000.
When you have equity in your home, the bank will lend you money. It's an asset with a measurable
value. Lenders are happy to accept it as a security deposit against your debt.
In return for lending you all that money, the bank takes an ownership stake in your home. But-and this is
important-that stake is limited to the amount of money you actually owe them. When your house is
worth more than what you owe, the excess value belongs to you, free and clear. That amount will vary,
though, because home values and loan balances change over time. If the home's value drops, your
equity goes down. If it increases, your equity accompanies it into higher levels.
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Guide to Home Equity Loans
http://www.mortgageloan.com/home-equity-loans/guide/
Home Equity Lending Lingo
Adjustable rate: A mortgage rate that's pegged to a specific economic indicator, such as treasury bills
or the prime interest rate.APR: The annual cost of the loan, including fees, interest, and points,
expressed as a percentage. Collateral or security: The property or asset that secures the debt. If the
debt's not paid on time, the lender has the right to foreclose.Fixed rate: A rate that's set at the time of
closing and remains constant throughout the mortgage term.Foreclosure: When the bank takes
possession of a property because the borrower doesn't adhere to the terms of the mortgage agreement.
Loan-to-value ratio or LTV: Expressed as a percentage, this number is the result of the mortgage
amount divided by the home's appraised value or selling price, whichever is lower. LTV helps the lender
determine how much debt you can comfortably handle. Most lenders are reluctant to lend 100 percent of
a home's value, because that leaves them no cushion if property values decline. Prime rate: A national
benchmark interest rate that commercial banks charge their best borrowers, generally large corporations.
Some home equity products are priced at a slight margin above or below the prime rate.Second
mortgage: Any loan that's subordinate to a first mortgage. Term: The length of time that you have to
repay your mortgage loan.
Do you have your bearings yet? Hopefully, you're feeling more comfortable about the whole subject of
home equity. The next step is to take a closer look at the different types of available equity financing.
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Guide to Home Equity Loans
http://www.mortgageloan.com/home-equity-loans/guide/
The Home Equity Family Tree
Home equity loan
A home equity loan is ideal for anyone who doesn't like surprises. It provides one lump sum payment
that you'd pay back in fixed monthly installments, generally over the course of 10, 15, or 30 years.
Unless you miss a payment, the maturity date and the interest rate won't change. This is the type of loan
that you could set up on auto-pay, and forget about until it's paid off.
Home equity line of credit
The home equity line of credit (HELOC), is a revolving debt with an approved credit limit. You can
borrow some or all of it. Once you repay it, you can borrow the money again. Monthly payments can be
low. Sometimes, you're only required to pay interest, or merely 1 percent of the outstanding balance.
HELOCs carry a variable interest rate tied to the prime rate. If the prime rate is 8.25 percent, and your
rate is "prime plus 0.25 percent," your rate would be 8.50 percent. Since the prime rate changes
periodically, your interest rate will move up or down during the life of the loan.
Now that you've met the second mortgage siblings, you're ready to start thinking about which one you
like better.
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Guide to Home Equity Loans
http://www.mortgageloan.com/home-equity-loans/guide/
Choosing the Right Home Equity Financing
Let's start with some general guidelines:
• Fixed-rate home equity loans are more suitable for a one-time, fixed expense.
• HELOCs are better for recurring cash needs.
• Home equity loans often have higher monthly payment requirements, and fit better
with borrowers who have steady cash flow.
• HELOCS have lower monthly payment requirements, and fit well with borrowers
whose incomes vary from month to month. The trade-off for lower monthly
payments is a more uncertain repayment schedule.
Home equity loans and taxes
Both home equity loans and HELOCs have the persuasive benefit of tax-deductible interest. You can
generally deduct the interest paid on the first $100,000. But be careful-if the market value of your home
drops below your indebtedness, the allowable deduction might go down as well. Always consult with
your tax advisor for the specifics of your situation.
Learning by example
Applying these guidelines to your life should be relatively straightforward. As an example, consider
fictional borrower John Smith, a real estate broker who earns a low monthly base salary, plus
commissions and quarterly bonuses. John wants to buy his daughter a car. A home equity loan is an
appropriate instrument, because he can easily budget for it on a monthly basis, since payments will be
fixed.
When John's not showing homes to prospective buyers, he's a do-it-yourselfer who wants to build an
addition to his home. Over the eight months it will take him to complete his project, he'll need to
purchase about $50,000 in supplies. It doesn't make sense to pay interest on the entire $50,000 from Day
1, when he only needs $10,000 to get his project started. If John chooses a line of credit in the form of a
HELOC, he can borrow the $10,000 at closing, and the other amounts as the project unfolds.
You don't have to be John Smith to make the right choice with confidence. If you're still stumped, a
trustworthy lender can (and should) provide some additional insight. But now, you're knowledgeable
enough to ask the right questions and benefit from the answers.
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Guide to Home Equity Loans
http://www.mortgageloan.com/home-equity-loans/guide/
Funding a Home Equity Loan
Loan Amount
You probably know how much money you need, but you may not know how much you can get. Lenders
will calculate your equity, but they generally won't lend you that entire amount. (Remember that LTV
definition from Chapter 2?) It's just too risky for a bank to lend you 100 percent of your home's value.
A better guideline is to calculate 80 percent of your home's value, and subtract your first mortgage
balance. The answer will be something close to what you can obtain from a home equity lender at the
lowest interest rate possible.
Application process
Once you apply for a home equity loan (HELOC), lenders will carefully review your income, your
employment status, your credit history, and the value of your home. This information is used to assess
how risky you are as a borrower. The riskier you are, the more expensive your interest rate will be. It's
also possible to have a no-documentation or low-documentation loan, but lenders have been tightening
their belts on these products as of late, and they're becoming harder to come by.
Closing costs
Costs associated with obtaining your second mortgage may include fees for the appraisal, application,
title search, and other closing services. If you have excellent credit, some lenders will waive these
expenses completely. Ask all prospective lenders for a written statement of estimated closing costs.
These figures have been known to change at the last minute, so prepare you by asking the lender how
such changes are handled.
Home equity debt can be an extraordinarily powerful financial resource; but it isn't right for everyone. If
you choose your path from a position of knowledge, you're already heading in the right direction, and
can enjoy the process as much as a smooth Sunday drive in the country.
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