Home Equity Borrowing
Home equity loans let you borrow using the equity you've built up in your home as collateral. You can often borrow more money at a lower interest rate than with other types of loans. You can choose between:
- Home equity loans, sometimes known as second mortgages
- Home equity lines of credit, sometimes called HELOCs
- They are easy to arrange
- The rates are usually lower than on unsecured loans
- You risk losing your home if you default on the payments
- Even if the value of your house decreases, the amount of your loan stays the same
- You may have to pay high closing costs
With a home equity loan, you borrow a lump sum, usually at a variable rate of interest although some fixed-rate loans are available. You pay off the debt in installments, in the same way you repay your mortgage, with some of each payment going toward the interest you owe and the rest toward the principal, or loan amount. At the conclusion of the payment period, the loan is retired.
You may have to pay closing costs on your loan, just as you did for your first, or primary, mortgage. But lenders may offer loans with no up-front expenses as part of a promotional deal. You might also be offered a teaser rate, or a period of low interest as an incentive to borrow. If that's the case, the lender has to tell you the actual cost, or annual percentage rate (APR), and when the temporary rate ends.
HOME EQUITY LINES OF CREDIT
Home equity lines of credit are actually revolving credit arrangements, which you can use in much the same way you use a credit card. Your credit line, or limit, is fixed, and you can write a check for any amount up to that limit. Whatever you borrow reduces what's available until you repay. Then you can use the repaid amount again.
The terms of repayment vary with the loan and are spelled out in your agreement. In some cases you begin to repay principal and interest as soon as you borrow, or activate the line. In others, you pay interest only, with a balloon, or one-time full payment of principal at some set date. Or, you may make interest-only payments for a specific period, and then begin to pay principal as well.
Most credit lines have an access period, often five to ten years, during which you can borrow, and a longer payback period. The longer you take to repay, the more expensive it is to borrow.
As a general rule, you can borrow up to 80% of your equity in your home with a home equity loan. For example, if you had a $75,000 mortgage on a home appraised at $250,000, your equity would be $175,000. In most cases, you'd be able to borrow up to $140,000, or 80% of $175,000.
Some home equity lines of credit, especially those offered without closing costs or other up-front expenses are capped at a fixed amount, such as $50,000. Each time you use your line of credit, your equity is reduced by the amount you owe. When it's paid off, your equity is restored. However, if your home loses some of its value during the loan period, you still owe the full amount you borrowed.
While home equity borrowing has a lot of advantages, it has one serious drawback: If you default, or fall behind on repayment, you could lose your home through foreclosure. That means the lender has the right to take over the property. That's true even if you've made all the payments on your first, or primary mortgage.
That risk is the chief argument against using home equity borrowing — lines of credit in particular — to pay day-to-day expenses. If you're using the money to make improvements in your home, pay tuition bills, or meet other major expenses, and include loan repayment as a regular item in your budget, home equity borrowing can be a wise choice. But if you're in the position of not being able to repay, you're exposing yourself to losing everything you've invested in your home — and having no place to live.
FINDING A LOAN
Home equity loans are generally easy to find. Banks offer them, and so do credit unions, mortgage bankers, brokerage houses, and insurance companies.
You can start by doing some research to see what's available. But before you commit yourself, you should get a description — in writing — of the specific rate, term, and other conditions of the loan you have decided to take.
SETTING THE RATE
Each lender sets the terms and conditions of loans it makes, though the basic elements are usually similar. If a home equity line of credit has a variable rate, it must be tied, or pegged, to a specific public index, often the prime rate, rather than to some internal index that the bank controls. Most home equity installment loan rates are also tied to an index, though federal law doesn't require it for this type of loan.
The lender adds a margin, expressed as basis points, or hundredths of a percentage point, to the index to determine the new rate each time it's adjusted. It may happen once a year or sometimes more often.
For older people with lots of equity but limited income, a reverse mortgage may be an alternative to selling their homes or depending on family members to meet their bills. A reverse mortgage allows owners to borrow against the value of their home, either by getting a regular monthly check (either for a fixed term or for as long as they live in the home), a line of credit, or some combination.
You can arrange for reverse mortgages through individual lenders, or the Home Equity Conversion Mortgage (HECM) program of the Federal Housing Administration (FHA). The amount you can borrow depends on your home's market value, your age, and the cost of the loan. In addition, some lenders impose caps on the amount they will lend.
While interest rates quoted on reverse mortgages can be similar to those for other mortgages, there are additional fees and charges that can make them more expensive than other types of loans. Lenders must provide a Total Annual Loan Cost disclosure form that estimates the average annual cost as an interest rate, or percentage of the loan. Before you borrow in this way, you must be counseled by a HECM approved counselor. A financial assessment is also required.