Home equity loans are currently one of the fastest areas of growth in the lending industry and for good reason. Home equity loans are one of the most secure types of loans for lenders and only have a 1.15-% default rate. Banks hate risk and home equity loans have extremely little risk thus making them great from a bank’s point of view.
To anyone who knows a little bit about how banks work the fact that a loan is good news for a bank should raise some warning flags that need to be investigated. The first thing to know is how a home equity loan works. The amount of equity in your home is the difference between how much money is left owing on your mortgage and what your home is currently worth. As a homeowner you may borrow the amount of equity that you have in your home and secure this loan with your home. For example, if you owe $175,000 on your mortgage and your home is worth $250,000 then you could get a home equity loan for at least $75,000.
The concept behind a home equity loan is a good one and there are some good reasons to consider one. Because of the security offered by your home, a home equity loan will be at a lower interest rate than other loans, the interest is tax deductible and the loan is amortized over 15 years instead of the normal 4 or 5 years. All of this means lower monthly payments and greater flexibility with your normal income.
The lower interest rates and longer amortization period for a home equity loan makes it ideal for certain applications. Home equity loans can be great for home improvement projects and for reducing credit card debt. $10,000 of credit card debt at 15% would require a monthly payment of $278 while a $10,000 home equity loan at 15% would only require a monthly payment of $140. This is a huge monthly saving and is why a home equity loan can and does make sense.
Of course there are some down sides to a home equity loan especially the home equity styled loans for up to 125% of your home’s equity. The first and biggest draw back is that your equity will vary each year. If real estate values suddenly drop you may find yourself owing more than your home is worth. Once a home equity loan exceeds the value of your home it is no longer considered secured and thus is subject to higher interest rates and the interest is no longer tax deductible.
This leads us to the next biggest downfall, and was a major problem during the depression. With a home equity loan the guarantor can force you to sell your home if you miss or get behind on your payments for any reason. Your existing mortgage must be paid off first with the proceeds of the foreclosure sale and the remaining amount of money, if any, is applied to the outstanding amount of the home equity loan. If there isn’t enough equity to repay the loan then the lender will proceed with a judgment against you for the remaining amount thus leaving you with no option other than bankruptcy.
As you can see a home equity loan is a great tool but the advantages of it must be weighed against the disadvantages. A home equity loan can mean lower monthly payments thus allowing you to get out of debt faster but can also mean even greater risk and debt if there is a problem, such as you run up all of your credit cards a second time or loose your job. Since none of us can predict the future it may be to your advantage to consider other types of loans, such as a home equity line of credit or a consolidated loan, before seeking a large home equity loan.