How Does a Home Equity Loan Work

Home equity loans have become increasingly popular in recent years, but what is a home equity loan, and what are its advantages and disadvantages?

What Is a Home Equity Loan?
The term "home equity loan" actually refers to two different types of loans: the home equity loan and the home equity line of credit. Both allow the borrower to take out a loan against the equity (the value of the home beyond what is currently owned) in his or her home. Where these loans vary is in how the money is distributed.

A home equity loan (HEL) grants the borrower money in one lump sum, where as a home equity line of credit (HELOC) grants the borrower access to a line of credit (much like a credit card) that can be accessed over time on an as-needed basis.

Common Home Equity Loan Uses
Home equity loans can be used for a variety of purposes, but the most common include:

  • Home improvements
  • Debt consolidation
  • Educational expenses
  • Financing a second home

The Good and Bad of a Home Equity Loan
To decide if a home equity loan is right for your needs, it's important to consider the pros and cons of such a loan.Pros

  • Often tax deductible.
  • HELs offer a fixed interest rate.
  • HELs offer a fixed monthly payment.
  • Offer lower interest rates than credit cards.
  • Allow you to borrow a large sum of money.
  • Relatively easy to obtain, even if you have bad credit.
  • HELOCs give you a line of credit that you can tap whenever you need.
  • Freedom to use the money as you see fit.

Cons

  • Defaulting on a home equity loan places your home at risk.
    HELOC interest rates change with the prime rate, so your loan could become more expensive over time.
  • You could lose your HELOC if your financial situation changes (loss of job, divorce, etc.)
  • There are many scam companies in the home equity industry. A bad loan could result in high interest, fees or the loss of your home.
  • Closing costs can be steep. Expect to pay points, an appraisal fee, an attorney fee and a fee for a title search.

Shopping For a Home Equity Loan
If you decide that a home equity loan is right for your financial needs, there are several questions you'll want to ask potential lenders to ensure that you are getting the best deal possible. These include:

  • What is the loan origination fee or points associated with this loan?
  • Is there a prepayment penalty?
  • If it's a HELOC, what is the interest cap?
  • Does this loan include a balloon payment at the end?

For a clear picture of the closing costs associated with a loan, insist that your lender draw up a good-faith estimate. This will provide an itemized report of all anticipated costs.

Closing the Deal
A home equity loan can be a valuable financial tool when used responsibly and with full understanding of all of the risks. Make sure you understand the terms of your loan offer before signing anything. A few questions could be the difference between a good loan and a really bad one.

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