A Primer on Home Equity Lending
By Charles Hopkins
Published 10/26/2007 | Loans
A Primer on Home Equity Lending
Some people, when cash is needed, opt to take out home equity loans or lines of credit. These basically allow you to borrow money against your home's equity or the difference between its market value and any claims, such as debts like mortgages, owed against it. These financial products allow you to turn this equity into cash. About a third of those who take out a home equity loan or line of credit spend this cash on investments like education or home improvements. The rest use it on purchases of quickly-devalued material possessions such as cars or spend it on vacations, use it for debt consolidation, or other expenses.
What is Home Equity?
To illustrate the concept of equity, let's say you bought a house worth 300,000 dollars and borrowed 250,000. Your equity will then be equal to the amount of the down payment, in this case 50,000. Fast forward to five years later. Let's say you've managed to pay back 45,000 of what you owe and that your house appreciated in value, assessed at 400,000. You take that value and subtract from it what you still owe, in this case 205,000. This means your current equity on the house is 195,000.
Lenders offer myriad variations, but there are two basic types of home equity financial products - home equity loans and home equity lines of credit. Both are also known as secondary mortgages because they are secured loans with the collateral being your property as with your primary mortgage. Secondary mortgages have a shorter lifespan than primary mortgages. Whereas primary mortgages usually last for 10 to 30 years, secondary mortgages are repaid in anywhere from five to 30 years. There are important differences between the two types of lending.
Home Equity Loans and Lines Of Credit
Home equity loans (HEL) are closed-end loans paid back in installment like regular mortgages. You are typically given an amount of cash all at once and pay it back on a schedule. They are usually offered at fixed rates with amortization periods of up to 15 years.
Home equity lines of credit (HELOC) are a type of revolving credit deal with the house as collateral. Under this open-ended setup, which can last up to 30 years, you will be given a credit limit, which is the maximum amount you may borrow at a time from the lender. This is usually pegged at a percentage of the home's appraised value minus the balance owed on existing mortgage. Thus, if the lender takes 75 percent of the 400,000 home mentioned in the example above and subtracts the 205,000 still owed, the homeowner's credit limit would be 95,000. However, this may be modified due to the fact that a lender takes other factors into account such as the borrower's credit rating and history, income, debts, and other existing financial obligations. A line is usually set at a variable interest rate.
It can cost a lot to set up a either a loan or a line of credit. There are fees to be paid such as stamp duties, fees related to the appraisal and title of a property, closing and early paying-off fees. You should question the firm you wish to obtain a loan from about these to avoid surprises.