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Benefits & Dangers of Having A HELOC

Home Equity Loans: What They Are & How They Work

A home-equity loan, also known as a second mortgage, lets homeowners borrow money against the equity in their homes. Home-equity loans provide a way for consumers to somewhat lessen the effects of that year's tax changes, which also eliminates deductions for the interest on most consumer purchases. Through home-equity loans, homeowners can borrow up to $100,000 and still deduct the interest when they file their tax returns. Now keep in mind that there are two types of these loans and both have benefits and traps to look for.

Two Types of Home-Equity Loans

Home equity loans come in two varieties - fixed-rate loans and lines of credit. Both types are available with terms that usually range from (5) five, (15) fifteen, (20) twenty, and (30) thirty years.

Fixed-Rate Loans
A Fixed-rate loan provides a single, sum of money paid to the borrower, which is repaid over a set period of time at an agreed-upon interest rate. The payment and interest rate remain the same over the lifetime of the loan.

Home-Equity Line of Credit
A home-equity line of credit, otherwise known as a HELOC, is a variable-rate loan that works a lot like a credit card. The borrower is pre-approved for a certain spending limit and can withdraw money when they need it via a credit card or special checks. Each monthly payment varies based on the amount of money borrowed and the current interest rate. Like fixed-rate loans, the HELOC has a set term. When the end of the term is reached, the loan amount must be repaid in full.

Benefits for Consumers

The benefits of home-equity loans are that it provides an easy source of cash. Although the interest rate on a home-equity loan is considerably higher than a first mortgage, it is much lower than a credit card or other consumer loans. The #1 reason consumers borrow against the value of their homes through a fixed-rate home equity loan is to pay off their credit card balances. The interest paid on a home-equity loan is also tax deductible, and by consolidating their debts with the home-equity loan, consumers get a single payment, a lower interest rate and tax benefits.

Benefits for Lenders

A Home-equity loan is a dream come true for a lender, who, earns interest and fees on the borrower's initial mortgage, and even more interest after fees. If the borrower drops out, the lender gets to keep all the money earned on the initial mortgage and all the money earned on the home-equity loan. The lender also gets to repossess the borrower's property, sell it again and start the cycle again with the next borrower.

Making the Best Use of a Home-Equity Loan

A home-equity loan can be valuable tool for a responsible borrower. If you have a steady source of income and know that you will repay the loan back, the low interest rate and tax deductibility of paid interest makes it a sensible choice. Fixed-rate home-equity loans can help cover the cost of a single, large purchase, such as new carpet, or unforeseen accidents. The HELOC also provides a convenient way to cover short-term, reoccurring costs, such as college tuition, or for car insurance.

Recognizing Traps

The main trap associated with home-equity loans is that they seem like an easy solution for a borrower who may have fallen into a cycle of spending, then borrowing, then spending until they sink deeper and deeper into debt. This is so common, that lenders have a term for it: reloading, which is basically the habit of taking out a loan to pay off existing debts and to free up additional credit, but which the borrower then uses to make additional purchases.

Often reloading pushes borrowers to turn to home-equity loans offering 125% worth of the equity in the borrower's house. This type of loan may come with higher fees, since the borrower has taken out more money than the house is worth. The danger of this is that the loan is not secured by collateral. Also, the interest paid on the portion of the loan that is above the value of the home is not tax deductible.

Another trap may open when homeowners take out a home-equity loan to finance home improvements. Although remodeling the kitchen or bathroom may add to the value of a home, extravagant improvements such as a swimming pool may be worth more to the homeowner than to the market determining the total value. If you find yourself going into debt when making cosmetic changes to your house, try to determine if the changes add enough value to cover their costs.

Should You Tap the Equity in Your Home?

Food, clothing and shelter are considered a necessity, but only shelter can be used to obtain cash. Despite the risks involved, the temptation to use home equity to splurge on expensive luxuries can be troublesome. To avoid the trap of reloading, review your financial situation carefully, before you borrow against your home. Make sure that you understand all the terms of the loan and have the means to make the payments without cutting out of other bills.