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When to Look into a Home Equity Loan

Home equity loans are loans in which the borrower, also known as the homeowner, uses the equity of their home as collateral for money received. Homeowners can use these loans for anything they'd like - major home repairs, medical bills, or their college education - so long as they are willing to accept the lien against their own home, a circumstance that reduces their home equity. Generally, you'll find that home equity loans come in the form of second trust deeds, and they require that the borrower be in very strong standing with their credit.

Keep in mind that there is a specific difference between home equity loan and a Home Equity Line of Credit. One, the Line of Credit, is a form of revolving credit with an adjustable interest rate, while the other comes in the form of one lump-sum loan. Usually home equity loans have a fixed interest rate, though you will find some exceptions.

Types of Home Equity Loans

Home equity loans are basically second mortgages on your home, and there are two different types of the loan that you can use.

Closed End Home Equity Loans

In this type of home equity loan, the borrower receives one lump sum at the closing of the loan agreement and cannot request any other amount of money. That said, homeowners have been known to borrow up to 100% of the appraised value of their home, less any liens that may occur, so there is a lot to gain from a closed end home equity loan. 

Open End Home Equity Loan

Open end home equity loans are more closely affiliated with lines of credit in which the borrower can choose when to borrow and how much he or she would like to borrow at the time. The lender sets an initial limit on the credit line, but generally homeowners can borrow up to 100% of the appraised value of their home - similar to that of a closed end home equity loan.

Advantages of Home Equity Loans

  • Less risk for the lender. A loan that's secured by real property cuts the risk on a loan considerably. That will pay off when it comes to home equity loan rates, which is something important to consider if you're using the money to pay down credit card principals.
  • Flexibility. You have the advantage of going for hard cash from your equity (called a closed-end home equity loan) or a "home equity line of credit." The second model allows you to use the house as a revolving line of credit, accessible with debit cards, checks or credit cards. You will only be charged interest on the amount actually accessed. Again, home equity loan rates (or line-of-credit rates) will be considerably lower than those on a credit card.
  • Tax advantages. At year's end, the interest paid on a home equity loan is fully deductible.

Disadvantages of Home Equity Loans:

 

  • Income. Carefully consider if you can really afford to go this route and take on one extra payment every month. With mid-2009 unemployment pushing 10%, think about your job security and income potential.
  • Bill consolidation. Think carefully about the amount you owe and how long you intend to spread out payments. If your debt isn't that big, a home equity loan might cost you more in the long run as you extend and spread out the payment schedule (despite the more favorable home equity loan rates).
  • Home value. Everyone knows the housing market has taken a horrible beating. If your area is hard-hit, think a little ways down the line. If your home's value goes down and you need to sell, you may not be able to pay off that home equity loan in the end.
  • Default. This may be the most important and nastiest thing to consider. Your home equity mortgage loan is backed with your home itself. If you default on the loan, you may face foreclosure even if you're OK on the first mortgage.
  • Retirement. If equity and resale value are part of your retirement plans, think carefully about all this home equity loan information before acting; it may cut drastically into your nest egg.
 

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