Learn About Home Equity Loans

A home equity loan is one in which you use the equity in your home as collateral in order to secure a revolving line of credit. Consumers typically use home equity loans in order to make major purchases or renovations or to fund major life changes. According to the U.S. Federal Reserve, consumers should be aware of complications and pitfalls when taking out a home equity loan. You should do your research beforehand to determine which type of loan is right for you.

How It Works

When applying for a home equity loan, the company considering your loan will start with the appraised value of your home. Then, it sets a credit limit, or a maximum percentage of the appraised value, that the company is willing to lend you. It converts that percentage into a dollar amount by multiplying the percentage into your appraised value. The company then subtracts the amount you still owe on your mortgage from the percentage of the appraised value it's willing to loan you, and that amount is the amount you are eligible for through a home equity loan. Companies will take other aspects of your credit into account when determining whether they will approve a home equity loan for you.

Once Approved

Most home equity loans must be paid back over a period of time, usually up to 10 years. Depending upon the terms of your original home equity loan, you may be able to renew the loan, or take out another home equity loan once you've paid off the original loan. One advantage to that home equity line of credit is that because it is a revolving form of credit, you can borrow from it, up to your limit, whenever you need to. So if you've paid off $2,000 of the loan, and you need $1,000 of it back, you can borrow against the balance.

What to Look For

The U.S. Federal Reserve said you should shop several plans and choose the one that best fits your financial needs. The Fed also said consumers should read all paperwork carefully, including the loan's terms and conditions, the annual percentage rate (APR) of the loan and any fees that could be involved in setting up the loan. It is incumbent upon the consumer to ask these questions during the application process.

Interest Rate

The interest rate is an important component of the home equity loan, as companies use both fixed and variable rates, depending upon the loan. If your home equity loan uses a variable rate of interest, make sure you know which index the rate will be based on. The Fed said the rate must be based on a public index such as the prime rate. You should also check to see whether the loan provider will charge a margin, which is a percentage of interest in addition to the public index it will use to figure interest. Variable rate plans are also, by law, required to have a cap on your interest exposure.

Costs

There are underlying costs to taking out a home equity loan, though some companies will roll those costs into the loan itself. But you should note costs such as a property appraisal fee, an application fee, upfront charges, such as points, and closing costs that can include attorney's fees, title searches and mortgage preparations. You should also watch to see whether there are any membership or annual fees, or transaction fees if you make a draw from the account. And remember, failure to repay the loan could mean the loss of your home.