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What's the Deal with Home Equity Loans?

By Charles Hopkins Published 10/26/2007 | Loans
A home equity loan is a financial product which enables consumers to borrow money based on the equity contained in their homes.  A home is probably the single greatest asset owned by a person.  A loan against its equity, or the difference between its value minus any claims, enables the homeowner to utilize this value at the cost of putting the house at risk and possibly foreclosing on it.  As with many other financial products, the home equity loan, if properly used, can be a valuable tool for the astute borrower.

Home equity loans are also known as second mortgages, creating a secondary-tier lien against the borrower's house.  Unlike first mortgages, which may last up to thirty years in case of fixed-rate deals, they are usually set for a shorter period - a lifetime of five to fifteen years is common.

Types of Home Equity Debt

Home equity loans come in two varieties.  One is a closed-end deal, which gives the money to the borrower all at once and is repaid over a period of time at an interest rate previously agreed upon.  The payment and the interest rate are fixed for the duration of the loan.  Once the deal has been approved, the person is not allowed to modify the amount they want to borrow.  The other is a line of credit, which functions similarly to a credit card, albeit at an often much lower interest rate.  In this kind of a deal, the borrower may borrow up to a certain limit and can withdraw the money when they want to via a provided credit card or special checks.  In this kind of a deal, which, like the home equity loan has a set term but comes with variable-rate interest, monthly payments are based on the amount borrowed and the current interest rate.  At the end of the set term, the loan should be paid in full.

One difference between the home equity loan (HEL) and the home equity line of credit (HELOC) is that it's faster to apply and receive money from the latter than it is from the former.

Benefits and Drawbacks of Home Equity Loans

There are several benefits to taking out a HEL or HELOC.  The first is that they are an easy source of cash.  If a person needs money to pay off educational fees, medical bills or do home improvements, they can resort to a home equity loan.  The second is that the interest rate, though higher than that of a typical first mortgage, is often much lower than that of a credit card.  Thirdly, the interest a consumer pays on a home equity loan is tax-deductible.  For the lender, it's a very good deal as well.  They get to earn and keep the interest and fees they levy from the initial mortgage and, with a home-equity loan, get to profit even more from the interest and fees.  If the borrower defaults, the lender keeps the money and also come into possession of property which they can sell.

The primary drawback to a home equity loan is also the ready availability of cash it poses, especially to a borrower who is seeking to pay previous debts by taking on new ones.  This practice of reloading, as it is called, can drive one into a never-ending cycle of spending, borrowing and sinking further into debt if not controlled.