Home Equity is the amount of ownership that has been built up in a property. Typically, residential property is bought through a mortgage, which is then paid off for a number of years. After the mortgage has been fully repaid, the property then belongs to the mortgager, namely the buyer. In the interim, however, the buyer simply builds up "equity" in the home. This equity is equal to the current market value of the home minus the outstanding mortgage balance. This is what a home equity loan borrows against. Although that equity cannot be sold, banks will lend money against it.
First vs Second Lien
Mortgagers often have a sizable amount of equity in their home; this equity can be used as collateral to obtain a large amount of credit for whatever purpose. Interest rates on home equity loans are fairly reasonable, although they are a bit higher than first mortgages. Since the first mortgager has the first lien on the property, the second mortgager-the bank giving the home equity loan-takes on the added risk of being second in line to collect if the loan goes into default. You can think of a lien as a claim on the property in case you, the mortgager, default on your loan. Whichever bank was first to give you a loan has the first claim, or lien, on your home. Since home equity loans can only be obtained after having a prior mortgage on the property, the home equity loan provider can only make a claim on your property after the first mortgage provider makes their claim (this only applies if you default on your loan). So it is because of this added risk that home equity loan providers charge a risk premium in the form of additional interest.
Home equity loans offer significant tax savings due to the fact that the interest paid on a home equity loan is tax-deductible. For example, consolidating debt from consumer loans into a home equity loan could result in a substantial cost savings due to the tax savings. Consumer loan interest is not tax-deductible, whereas home equity loan interest is.
Home equity loans are often used to consolidate other debt with high interest rates (like credit card debt), to finance large expenses (such as college or a wedding), or to purchase other costly items. This should only be done if the benefits of taking out the home equity loan (interest savings) outweigh the costs (fees, risk). Anyone considering a home equity loan should take note that the added risk of another lien against a home is costly. If payments cannot be made on either loan (the first mortgage or the home equity loan), both loans will go into default. This could result in the loss of the property and two creditors intent on collecting any remaining debt.
Types of Home Equity Loans
There are two main types of home equity loans.
- The first type is the traditional home equity loan, also known as the second mortgage, which lends out a lump sum of money that must be repaid over a fixed period.
- The second type is the home equity line of credit, which provides the borrower with a checkbook or a credit card that is used to borrow funds against the home equity.
Funds borrowed from a traditional home equity loan start accruing interest immediately after the lump sum is disbursed; funds borrowed from a home equity line of credit do not begin accruing interest until a purchase is made against your equity.
After deciding which type of loan is best for you, the next step is to decide on the type of interest rate for the loan. The Annual Percentage Rates will differ depending on the type of loan (second mortgage or line of credit). The APR for a second mortgage is calculated based upon the interest rate, other finance charges, and points. The APR for a line of credit is based only upon the interest rate; it does not include any of the other charges.
There are several repayment options; the best one for you depends on your financial situation and whether your interest rate is variable or fixed.
- One option is for the mortgager to make payments toward both the principal and the interest accrued.
- A second option is paying only the interest in the beginning, and then gradually repaying the principal.
- A third option is similar to the first option, except that more money is paid each period, resulting in the principal being paid off quicker (although sometimes lenders charge pre-payment penalties).
It's important to shop around at several different banks to get the best rates and the best terms. Don't necessarily choose the bank that gave you your first mortgage when deciding which bank to go to for your home equity loan.