Home Equity Loans
A home equity loan, or line of credit (HELOC), allows you to borrow money using your home's equity as collateral. This essentially is a second mortgage that lets you turn equity into cash, allowing you to spend it on home improvements, debt consolidation, college education or other expenses.
To begin, let’s make sure we understand these two important definitions:
Collateral is property that you pledge as a guarantee that you will repay a debt. If you don't repay the debt, the lender can take your collateral and sell it to get its money back. With a home equity loan or line of credit, you pledge your home as collateral. You can lose the home and be forced to move out if you don't repay what you’ve borrowed.
Equity is the difference between how much the home is worth and how much you owe on the mortgage (or mortgages, if you have a home equity loan or line of credit).
Example: Your home goes UP in value
Let's say you buy a house for $150,000. You make a down payment of $20,000 and borrow $130,000. The day you buy the house, your equity is the same as the down payment -- $20,000. $150,000 (home's purchase price) minus $130,000 (amount owed) = $20,000 (equity).
Fast-forward five years. You have been making your monthly payments faithfully, and have paid down $13,000 of the mortgage debt, so you now owe $117,000. During the same time, the value of the house has increased. Now it is worth $200,000. Your equity is $83,000: $200,000 (home's current appraised value) - $117,000 (amount owed) = $83,000 (equity).
Example: Your home goes DOWN in value
In the housing meltdown that affected many parts of the country, homes lost value. Instead of increasing in value, the value of the house dropped after the home was purchased. In many instances, a home equity loan would not be available.
Using the previous example, let's say you buy a house for $150,000. You make a down payment of $20,000 and borrow $130,000. During the next five years, you paid down $13,000 of your mortgage debt. This leaves you with a balance of $117,000.
However, as home prices fell and homes in your neighborhood went into foreclosure, your home's value dropped by 30 percent, or $45,000, to $105,000. So now your home is worth $105,000, but you still owe $117,000. Because the value of your home is less than the amount you owe, you have egative equity and would not be eligible for a home equity loan.
Types of Home Equity Debt
There are two types of home equity debt --- home equity loans and home equity lines of credit, also known as HELOCs. Both are referred to as second mortgages because they are secured by your property, just like the original mortgage. Home equity loans and lines of credit usually are repaid in a shorter period than first mortgages. Most commonly, mortgages are set up to be repaid over 30 years. Equity loans and lines of credit often have a repayment period of 15 years, although it might be as short as five and as long as 30 years.
A home equity loan is a one-time lump sum that is paid off over a set amount of time, with a fixed interest rate and the same payment amounts each month. Once you get the money, you cannot borrow further from the loan.
A home equity line of credit works more like a credit card because it has a revolving balance. A HELOC allows you to borrow up to a set amount for the life of the loan. During that time, you can withdraw money as you need it. As you pay off the principal, you can use the credit again like a credit card. A HELOC gives you more flexibility than a fixed-rate home equity loan. It also is possible to remain in debt with a home equity loan, paying only interest and not paying down principal.
Terms and Repayment
A line of credit generally has a variable interest rate that fluctuates over the life of the loan. Payments vary depending on the interest rate, the amount owed and whether the credit line is in the draw period or the repayment period. During the equity line's draw period, you can borrow against it and the minimum monthly payments cover only the interest, although you can elect to pay principal. During the repayment period, you can't add new debt and must repay the balance over the remaining life of the loan.
The draw period often is five or 10 years, and the repayment period typically is 10 or 15 years. Those are generalizations, and each lender can set its own draw and repayment periods. A line of credit is accessed by check, credit card or electronic transfer requested by the consumer. Lenders often require you to take an initial advance when you set up the loan, withdraw a minimum amount each time you dip into it and keep a minimum amount outstanding.
Finally, with either a home equity loan or a line of credit, you must repay the loan in full anytime you sell the home.