Home Equity Loan - Explained
What is a Home Equity Loan?
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Table of ContentsWhat is a Home-Equity Loan?How Does a Home-Equity Loan Work?Tax Considerations for Home-Equity LoansHome-Equity Loans vs. Home-Equity Lines of CreditPros of Home-equity loansCons of Home-equity loansQuestions to Consider When Shopping for a Home-Equity LoanThe Bottom Line on Home-Equity Loans
What is a Home-Equity Loan?
A home-equity loan refers to a type of loan in which a homeowner uses the equity of his home as a collateral for a loan. A home-equity loan is a consumer debt which is secured by a second mortgage, in this type of loan, a homeowner borrows against the equity of his home. Hence, the value of the home or property determines the amount of loan the homeowner can access. Also, the difference between the current value of the property and the mortgage balance of the homeowner determines the loan amount.
How Does a Home-Equity Loan Work?
In a home-equity loan, the equity of the home of the borrower serves as the collateral for the loan. It is a type of mortgage in which a lender issues a borrower an amount of loan based on the current market value of the property. Before a home-equity loan is given, ab appraisal is done on the property to determine its value. A combined loan-to-value (CLTV) ratio is one of the metrics used in determining the value of a home, about CLTV ratio of 80% to 90% of the appraised home determines the amount a homeowner can borrow. The credit rating or credit score of the homeowner is also important in determining the amount a homeowner can borrow.
Tax Considerations for Home-Equity Loans
Just like every other type of loan, a home-equity loan has a repayment schedule and interest rate charged. Depending on the repayment plan, a homeowner is expected to make regular payments on fixed dates until the loan is paid in full, including the principal and interest. The Tax Reform Act of 1986 allowed elimination of deductions on interest on consumer purchase, the home-equity loans became popular after the passage of this act. However, despite this provision, interest on service of home-based debt was exempted. The 2017 Tax Cuts and Jobs Act was the federal act that finally discontinued the deduction for interest paid on home equity loans and home-equity lines of credit.
Home-Equity Loans vs. Home-Equity Lines of Credit
There are two types of home-equity loans:
- Fixed-rate home equity loans
- Home-equity lines of credit (HELOC).
While a fixed-rate home equity loan allows a borrower or homeowner access a lump-sum of money at once, HELOC is like a credit card loan that allows a borrower access certain amount of funds as they need it. In a fixed-rate home-equity loan, after a lump sum payment is made to a borrower, the borrower repays the amount over a period of time at an agreed interest rate. HELOC on the other hand, is a line of credit in which a borrower can access a certain amount of money and repay repeatedly, that is, you borrow an amount and pay back repeatedly. A loan taken in a fixed-rate home-equity can be repaid over an agreed period of 5 to 15 years but in HELOC, a borrower can only draw money as needed and at a term decided by the lender.
Pros of Home-equity loans
- Home-equity loans as a second mortgage is a secured debt that can easily be accessed by consumers.
- The amount of a home-equity loan is dependent on the value of the mortgage used as a collateral. Borrowers that have creditworthiness are at an advantage.
- Home-equity loans is an easy way through which borrowers with good credit ratings can access funds.
- It is favorable for borrowers with a regular flow of income as they are able to repay the loan.
- Home-equity loans have certain tax deductions benefits and low interest rates.
- This form of consumer debt allows homeowners borrow loans for bigger and more-expensive projects.
Cons of Home-equity loans
- Home-equity loans carry great risks in the sense that they create a perfect avenue for a consumer to fall into the trap of borrowing and spending, thereby growing deeper in debt.
- Most home-equity loans have reloading options that allow homeowners make additional purchases by paying off an existing debt to take a new one.
- Reloading option looks attractive but it is a cycle of debt that homeowners must avoid.
- Home-equity loans are easy loans, therefore, a homeowner can borrow more than they need.
- Taking too much loan using home-equity loans can expose a homeowner to the risk of default, bankruptcy and foreclosure.
Questions to Consider When Shopping for a Home-Equity Loan
There are important questions a homeowner should ask himself before taking a home-equity loan. The major questions include:
- The homeowners ability to live with their means when the equity of the current home is 100% owned by them.
- How god is your creditworthiness as a homeowner?
- How well can the homeowners cope with the payment of interest rates?
- How financially stable are you as a homeowner?
- DO you have a steady and regular flow of income to repay the debt?
- What is the value of your home after an appraisal is done?
- Do you have a tendency of going into default or bankruptcy?
- You home is a collateral in the loan, do you have the financial ability is takes to prevent default and your home from being foreclosed?
The Bottom Line on Home-Equity Loans
A home-equity loan is a form of consumer debt issued to a homeowner who uses his home as a collateral. Homeowners are allowed to borrow against their equity in the home. There are two categories of a home-equity loan, a fixed-rate home equity loan and a home equity line of credit (HELOC). Generally, the amount of loan a borrower can access in home-equity loans is determined by the value of the property used as collateral. Hence, a homeowner who takes a home-equity loan is putting is home on the line, thi means the home can be foreclosed in the case of default or bankruptcy of the homeowner.