Information About Home Equity Loans

Loans are sometimes necessary for life's larger expenses, such as an unexpected medical bill or costly home renovations. To borrow a large amount of money, collateral is often required by the lender. Collateral acts as an insurance policy for a loan; the lender can sell the collateral to recover its losses if the borrower defaults on the loan. A home equity loan is a kind of second mortgage that uses the borrower's home as collateral for the loan.

Function

A home equity loan uses the fair market value of the borrower's home to determine the loan amount the borrower qualifies for. The loan is dispersed in one lump sum for immediate use and is repaid monthly through a fixed payment plan.

Terms

To qualify for a home equity loan, the borrower must be able to show proof of homeownership, income, home equity and mortgage payments that show at least 20 percent of the home's value is paid off. The bank may require an appraisal of the house to determine its value. Home equity loans may have fixed or adjustable interest rates, and the loan repayment term ranges from one year to 30 years.

Benefits

A home equity loan may be easier to qualify for than traditional loans since a house is being put down as collateral in case of default. This may make it easier for people with bad credit to qualify for a loan. Home equity loans may have lower annual percentage rates and higher loan amounts than other loans because such large collateral is on the line. Access to a large lump sum may be beneficial for borrowers who need to pay for large expenses such as college tuition or medical bills.

Considerations

By offering a home as collateral for a loan, borrowers are at risk of losing their homes if they fall behind on payments. Also, for large loans, borrowers should consider that the repayment term may span over decades. While the borrower may be able to borrow up to 100 percent of the home's value minus any outstanding mortgage debt, it may be beneficial to only borrow the amount currently necessary.

Warning

The Federal Trade Commission also warns about predatory lending schemes that tend to target minorities, the elderly and low-income families (see Reference 1). Borrowers may end up losing their homes in such schemes. Before agreeing to a home equity loan, the FTC recommends that borrowers fully read the contract, make sure there are no blank spots in the contract and keep careful financial records. Also, it is important not to borrow more than the home's fair market value.