We've all been there: life deals you a bad hand, and unexpectedly you need money you don't have. At times like this, it's important to remember the best asset you have: your home. You might consider refinancing as a way to help you through the tough times.
One option you have is a home equity loan. Home equity lines provide homeowners with quick access to extra cash in times of need.
What is a Home Equity Loan?
A home equity line of credit allows you to borrow against the value of your house. The cap on the loan is usually determined by estimating a percentage of the value of your house - 75% or 85% of the house's value, if your credit is good - and subtracting what you still owe on the first mortgage. Home equity lines usually allow you to draw from the account using special checks or credit cards. The terms of the specific loan will determine the length of the loan, the length of the "draw period" (the period of time during which you can withdraw money on the loan), the interest rates, the minimum and maximum amount that you can withdraw at any one time, and the method and payments with which the loan will be repaid.
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For instance, some home equity loans may credit payments only against the interest due on the loan, leaving the borrowed amount to be paid in full at the end of the loan period. Other loans may simply have a larger-than-usual payment, called a balloon payment, as the last payment. However, it may be helpful to note that the interest you pay is usually tax-deductible, meaning that you will get it back on your tax returns; if managed correctly, this "bonus" money can balance the impact of a large final payment on the loan.
In contrast, taking out a second mortgage on your house will give you the borrowed money all at once. Mortgages usually have fixed interest rates, which might be set slightly higher than the introductory rates on a home equity loan. On the bright side, though, the rates and payments on a second mortgage won't change, whereas the variable interest rates of a home equity loan may mean a payment that increases steadily over the years.
Shopping for a Home Equity Loan
Shopping for a home equity line of credit is like shopping for almost anything else: lots of different lenders provide lots of different choices. In order to make the choice that will best serve your needs, you should be prepared to obtain and compare quotes from many different lenders.
Most home equity loans have variable interest rates, which are determined by an index. When comparing home equity loans, you should know the index that each loan uses to determine your interest rate. Variable interest rates also have a couple of caps that are important for you to know, as they limit how far and how fast the interest rate can rise. The periodic cap limits how much the rate can change at one point in time, and the lifetime cap limits how much the rate can change over the life of the loan. It's also important to know whether the rate you've been quoted is a discounted introductory rate; if so, make sure you know how long the introductory period is, and what the rate will go up to when it's over.
If you are comparing a home equity line of credit to a second mortgage, understand the differences between them. Primarily, when comparing the costs of both, realize that the APR quoted to you on the second mortgage will be the only cost of the loan, whereas home equity loans also have account fees and other charges that are not built into the APR.
Costs to Consider
"For a true comparison of credit costs, compare other charges, such as points and closing costs, which will add to the cost of your home equity loan," the Federal Trade Commission (FTC) advises in their document, "Home Equity Credit Lines." The Truth in Lending Act requires lenders to be open about the terms and costs of a loan, but you may need to ask for this information up front if you are comparison-shopping before committing to any one lender.
o Application fee - In order to qualify for credit, you will have to submit an application to the lender. This application will allow the lender to check your credit score and your debt-to-income ratio, two important factors in determining your credit worthiness. Be aware that your application fee probably won't be returned to you if you fail to qualify for the loan.
o Appraisal fee - The lender will want to first appraise your house in order to determine the value of the property. From that appraised value, they will determine your line of credit. Appraisal fees can be considerable, and should be compared between lenders as one of the costs of the loan.
o Up-front charges - The lender may assess charges for setting up your account. These charges may vary considerably between lenders, so it's wise to compare these charges when deciding between multiple home equity loans.
o Closing costs - Just like when you bought your house, you may have to pay closing costs when you get a home equity loan. "These expenses can add substantially to the cost of your loan, especially if you ultimately borrow little from your credit line," the FTC states. Different lenders feature different closing costs, so any comparison of home equity loans should take these costs into consideration.
o Interest rates - Interest rates determine how much interest you will have to pay over the life of the loan. In order to compare multiple loans, you'll need to be able to see the "full picture" of what the loan will cost you, which includes the interest rates as well as the other fees and charges the loan will accrue.
o Account fees - Home equity lines often have continuing fees associated with the account, such as transaction fees, maintenance fees, or an annual membership fee. These fees will also vary between lenders, and should be compared as one of the costs of the loan.
Keep in mind that a home equity loan with low interest rates may make up the difference in other costs. For that reason, when shopping for the best deal it's a good idea to assess all costs associated with each loan.
Using Your Home Equity Line of Credit Wisely
"Because the home is likely to be a consumer's largest asset, many homeowners use their credit lines only for major items such as education, home improvements, or medical bills and not for day-to-day expenses." This statement, made by the Federal Reserve Board in their document, "When Your Home is on the Line: What You Should Know About Home Equity Lines of Credit," reminds us that home equity loans should not be taken lightly. After all, if something goes wrong and you cannot repay the loan according to your terms, you risk losing your most important possession of all: your home.
The FTC notes, "Because home equity loans give you relatively easy access to cash, you might find you borrow money more freely." The temptation to spend freely will be there, so it will be up to you to remind yourself that you risk losing your home if you let your spending get out of control. Borrow only what you need, and what you know that you can repay according to the terms of your loan. The equity on your home can provide relief in times of difficulty, but if you abuse that privilege, you risk losing the most valuable asset you have.
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