While a home equity loan may be similar to a home equity line of credit (HELOC,) in many aspects, some minor distinctions that differentiate the two products.
First, the similarities. Both use the borrower’s home as collateral based on the amount of equity so far accumulated in the home. Likewise, both are used for various purposes like financing home improvement projects, and paying of various types of debt (credit cards, student loans, and other loan accounts.)
Compared to other loan products, the home equity loan and HELOC carry lower interest rates that can be used for tax write-offs.
As previously mentioned, there are subtle differences between a HELOC and a home equity loan. Thus, borrowers are advised to evaluate both products carefully to determine which one is the appropriate package for them.
Home Equity Loan Acting as a Second Mortgage
When you take out a home equity loan, you receive a lump sum amount payable over a pre-determined timeframe with a fixed rate of interest. It is similar to an auto loan or a mortgage in this regard.
The maximum amount you can borrow depends on your home equity, which is simply your home’s current value less the amount still owed. To illustrate, let’s say your home is presently valued at $180,000, and you still have payables amounting to $135,000. Your home equity is therefore $45,000.
In most cases, lenders will offer a loan-to-value ratio of 80%. Thus, for the above example, your home equity of $45,000 will allow you to apply for a loan of as much as $36,000 ($45,000 x 80% = $36,000.)
You will get the proceeds in one lump sum amount that you can use to take care of financial needs such as settling other debts and to funding a home improvement project. Monthly loan payments usually start immediately at a fixed interest rate determined by your lender based on your credit score. A typical payment period for a home equity loan is 25 years, and interest rates, on the average, are currently at 6%, with the lowest at around 4%.
A Word of Caution
You will find a home equity loan quite useful if you need to have quick access to funds for gainful purposes such as getting a college diploma to improve your job marketability or to enhance the value of your home. There are, however, some drawbacks that you have to consider before finally deciding on using a loan with your home equity as collateral.
First, a home equity loan, as the name implies is secured by your home. If, because of an unexpected stroke of bad luck like losing a job or contracting a serious ailment, you are unable to keep up with your payments, you may lose your home if it goes into foreclosure.
Likewise, if you are still under mortgage, interest charges and closing costs can quickly pile up. If you opt to settle early, an early termination fee may be charged.
There is also the real estate market volatility that you have to consider. Because home equity isn’t static, your home equity can plummet quickly if home values sharply decline like what happened in 2008. You would find it very hard to sell your house if your home equity is adversely affected by a volatile market.
If your area’s real estate market tends to have significant price swings, you may be better off considering other alternatives like mortgage modification, instead of going for a home equity loan.