Want to renovate your home or purchase a big-ticket item? A home equity loan or line of credit may be just the ticket-but beware of the risk and dangers they may hold.
By Carol Johnson
One of the most popular loans today, for homeowners who need extra cash, is a home equity loan or line of credit. For homeowners with equity in their homes, sometimes borrowing against that equity can provide enough money to add on, renovate, or otherwise upgrade their home, or perhaps purchase a new car, a boat, or a lavish vacation they wouldn’t otherwise be able to afford. The advantage of a home equity loan is that you already have collateral for the loan, and if your mortgage is also with the same bank, you will already have an established relationship with the bank.
However attractive a home equity loan or line of credit may seem to be, you need to be aware of the dangers that exist, and the risks you may be taking by putting your home on the line. Before deciding which type of loan is the best for you, you need to know the difference.
A home equity loan is just like any other type of loan – you get a lump sum of money, and you have to pay it back in equal payments over a set amount of time, usually with a fixed rate of interest. A home equity line of credit is a type of reserve line of credit, that you can tap into whenever you need it, and the interest rate is usually variable.
No matter which option you choose, you need to remember that you are borrowing money against the equity you have accumulated in your home. If anything goes wrong during the term of the loan, or you fail to make payments appropriately, you could lose your home.
As an example of how a home equity loan works, let’s assume that you have a remaining balance of $30,000 on your mortgage. If you have your home appraised, and the market value of the house is found to be $150,000, then you have $120,000 of equity in your home. Many lending institutions will grant a home equity loan or line of credit up to 80% of the equity in your home, if you have good credit. In the case of this example, the homeowner would be able to borrow up to $96,000.
That sounds like a terrific deal, but you need to remember that the monthly payments on your home equity loan, will be in addition to your mortgage payments, and you may be making them for a long time. Be sure that you can handle the two payments, in addition to other regular bills you have to pay.
With a standard home equity loan, the interest rate is fixed from the beginning of the loan, and you pay back the money in fixed monthly installments over the life of the loan, just like your mortgage. But the trap is that, lenders sometimes use a lower introductory rate, to lure homeowners into selecting a home equity line of credit instead. Why an equity line of credit? Remember, I had told you in the previously that interest rates are variable, that can be lowered or raised frequently.
The initial lower rate may last for several months or a year, but after the introductory period, the rate will jump back up to the bank’s prime rate. A home equity line of credit works just like a revolving credit card account. The monthly payment is usually about 2%, of the outstanding principal amount of the loan.
Just like credit card accounts, interest is added to your balance as time goes on, and your interest rate may be adjusted higher during the life of the loan. As your interest rate rises, you have to be careful that the monthly payments will also cover the increased monthly interest payments, or else your balance will go up instead of down.
One more point to mention is that, you shouldn’t get a credit card attached to your home equity loan. The card lets you tap into your home equity, adding to the balance of your loan, and you can’t pay off those charges in one or two months, like you can with a credit card account.
A home equity loan or line of credit can be a great option for homeowners in dealing with emergencies, or for buying big-ticket items you would otherwise not be able to afford. You can also use either type of loan to consolidate all of your bills, into one payment, at an interest rate lower than the ones charged by credit cards.
But it’s important to know exactly what you’re getting into. Therefore, read the fine print, and ask questions before committing yourself. The common pitfalls you might encounter, if you don’t arm yourself with information, would not only affect your wallet, but may cost you your home. So be sure to do your “homework” first, and then enjoy the financial freedom you’ve earned by earning equity in your home.