Pros and Cons of Home Equity Loans

Charlie S Jan 8, 2019
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A home equity loan (HEL) is borrowed by an owner, by trading his home as collateral or security with a bank or financial institution. The pros and cons of opting for such a loan, are discussed here.
Home equity loans are borrowed to serve many purposes. Businessmen use the borrowed money to expand their businesses. Parents may opt for these loans to finance their child's education. Compared to credit cards, home equity loans come with a lower rate of interest.

What is Home Equity?

The value of 'home equity' is calculated by deducting the outstanding balance of liens from the actual market value of a home.
The actual market value of a property can be calculated through detailed research of the real estate market. Home equity loans are also be referred as "second mortgage loans".
However, there is a difference between them and home equity line of credit (HELOC). HELOC does not have a fixed credit limit and the interest rates are variable. On the other hand, home equity loans have a credit limit and provide a lump sum amount, at a fixed rate of interest.
There are many things which banks/financial institutions consider, before sanctioning such loans. The credit history of the loan applicant is studied carefully.
The loan application may get rejected if it is found that the applicant has not cleared his previous dues. Individuals with good credit history get preference while sanctioning loans. The credit score can decide whether the applicant is creditworthy or not.

Advantages

Banks prefer to forward loans by taking property as collateral. The reason for this is the assurance that if the borrower defaults on the payments, the bank can recover its money by auctioning off the property. The process of applying for these loans is simple and inexpensive.
These loans may be used for debt consolidation, covering medical treatment costs, and emergencies. The most striking advantage of opting for these loans is the rebate provided in income tax. Along with the loan, the lender provides the homeowners with an insurance policy.
There are two types of home equity loans - closed end and open. In closed end HELs, the loan applicant receives the entire amount at the time of closing. He cannot borrow any money further. Closing is the last step in the execution of a real estate transaction. In some cases, banks sanction a loan up to 100% of the home value.
The main point considered here, is the income of an applicant. Stability of income assures the bank that it will get its equated monthly installments (EMIs) on time. Closed end HELs have fixed interest rates and a repayment period of around 15 years.
In the case of open end HELs, the borrower is free to choose when and how often to borrow against the equity. Like closed end HELs, they can get up to 100% of the value of a home. This loan has a repayment period of about 30 years with variable interest rates. The EMIs can be as low as the interest that's due.

Disadvantages

There are certain cons of opting for these loans. The biggest disadvantage to the borrower can be the permanent loss of ownership of his property, if he defaults in payment of the EMIs. As the duration of the loan is high, the homeowner may face serious problems, if the market value of his home goes on declining.
Sharp decrease in home prices is common during phases of recession. To avoid this, borrowers should think about their ability to repay in the future. Apply for a home loan, only when you are financially well settled.
Elderly people should be well aware of the complications involved in repayment as they are nearing retirement. Floating interest rates increase the EMIs by large amounts and disturb our monthly budget as the monthly income is fixed. A businessman should have faith in himself that he will earn a decent profit on his investments.
Make a clear analysis of your current and projected future financial position, before opting for such a loan.