Home equity loan is a type of loan that allows house owners to take a loan based on the equity in their houses. Equity is the share of the house that has already been paid for. In other words, while house owners might still have money left to pay to actually fully own their houses, they still can take a loan on the amount they already paid (represented in the house).
This is like taking a second mortgage on your house. In this case, the bank decides to lend a house owner money based on the percentage they’ve paid of the house’s total cost.
Generally speaking, an owner needs to have 20% of the house’s value in equity before qualifying for a home equity loan. This means that if you own a $100,000 house, you need to have paid $20,000 of the mortgage. Since home equity loans are considered a second mortgage, interest rates are generally higher because of the risk involved.
Why would you want to take a home equity loan?
A home equity loan becomes useful when the property value in your neighborhood increases. When that happens, you become richer than you think. However, you can’t feel richer because money is locked in the form of a property.
This is definitely one incident when taking a second mortgage is useful, since you can use such money to invest elsewhere. One incident when it’s not particularly rewarding is to use the entire loan as an expense for short-time fulfillment.
What are your options when it comes to home equity loans?
There are two options when it comes to taking a second mortgage:
Home Equity Loan: represented in a single sum of money with a fixed interestrate. It becomes particularly useful in investment or one-time deals.
Home Equity Line of Credit: which is when the sum of money is available, but you only pay interest on the amount you actually withdraw or use. Withdrawal is subject to interest rate variability. This is the same idea behind a credit card. This becomes particularly useful when working on a long term project that rather requires multiple payments on different time intervals.
What are the pros and cons of each option?
Home Equity Loan
Pros:
Fixed interest rates allow you to budget your monthly payments.
Interest paid is usually tax deductible.
Cons:
If the loan is not used wisely, it becomes a burden.
If property value drops, it becomes useless.
Home Equity Line of Credit
Pros:
Interest is paid only on the amount you withdraw.
Interest paid is usually tax deductible.
Cons:
If interest rates rise up, you end up paying more.
If not used wisely, you can end up spending more than allowed.
It is important to understand that while failure to pay the first mortgage doesn’t exactly mean you lose your house, failure to pay the second will result in losing your property. This is because there are two payments in line; the mortgage and the loan.
This is why it is advised to use such loans wisely and in investments that have the potential of creating a positive cash flow.
