HOME EQUITY LOANS

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HOME EQUITY LOANS

Published by sam - 11/09/07 - 01:09:14 am

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The home equity—a loan secured by the equity you have in your home—has become increasingly popular in recent years. These loans use your home as collateral and carry variable or fixed interest rates. They should be avoided.

There are several reasons these loans remain popular. For one, you are able to borrow a larger amount of money at a lower interest rate than would be available through a personal or automobile loan. More enticing is the fact that the interest on a home equity loan remains largely tax deductible, whereas the tax deductibility of all other forms of non mortgage consumer loan interest will have been phased out by 1991. These attractions make a home equity loan extremely tempting, but the dangers of foreclosure in case of default must be considered very carefully.

The equity loan is based on the market value of your home and your current equity in it. That is , if your home is worth $100,000 and you have paid off all but $20,000 on your mortgage, your equity is $80,000 and you are likely to be able a loan amounting to about 80 percent of this figure.

Home equity loans are available in two forms—the traditional second mortgage and the much more recent type of loan advertised under the term”home equity loan”. Although both are based on your equity in the home, they differ in a number of important respects.

Second Mortgages

One form of equity loan—the second mortgage –has been in use for decades, but its reputations has been tarnished ever since the Great Depressions, when homeowners were forced to use it as their only source of cash to pay for daily necessities. In many ways, however it is preferable form home equity loan.

Like a first mortgage, the second mortgage provides you a specified sum of money at a fixed rate (although some variable rate second mortgages are available) and provides for repayment in a number of monthly installments that include amortization as well as interest. Although it is likely to involve points and other closing costs that can amount to $500 to $1,000 its lower interest rate and its tax deductibility make it preferable to a large, long term personal loan. It does, however expose your home to the risk of foreclosure, a danger that will be elaborated further in connection with home equity loans.

The New Home Equity Loans

Unlike the second mortgage, the newer form of home equity loan, developed in the mid-1970’s, has proliferated widely since 1987, when the interest on other forms of consumer credit was no longer fully tax deductible.

Whereas a second mortgage or a personal loan specifies a fixed principal and a fixed schedule of repayment, the home equity loan need not specify either. Instead, as in the case of a credit card, you are given a credit limit on which you can draw at any time for some purpose. Repayment requirements vary widely. Some require a schedule repayment of interest and principal. Others requires interest payments only for a specified term, followed by payments that include principal and interest. Still others involve payment of interest only with a balloon payment at the end of a specified term.

Although the interest rate on this kind of loan—as low as four percentage points below the rate for personal loans and seven percentage points below that for credit cards—may be attractive, origination costs are likely to be high. Aside from closing costs—for appraisal, paperwork, and so on—each point on a home equity loan is calculated as 1 percent of the credit limit that the lender establishes and not of the money actually borrowed. On adjustable rate home equity loans, lenders are not required by law to include such costs in calculating the annual percentage rate, and the quoted rate may be misleading low. Even if the true rate is attractive the additional costs make a home equity loan worth taking only if the amount of the principal is substantial and the term of the loan relatively long—but in such circumstances the threat to your home may be considerable.

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September 11, 2007 | Loans, Banking |

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