Q&A: Home Equity Loans and Lines of Credit: Pros, Cons, Risks, Benefits

What is a Home Equity Loan and Home Equity Line of Credit?

These loans are similar to many other types of secured loan, but in this case the security is the value of your home. There are two main kinds of loans based on the equity you have in your home:

• the home equity loan is normally granted as a single lump sum, or series of such loans and you are required to pay a set monthly amount (principle and interest) - it is very similar to traditional home mortgage, secured by the equity in your home that may have increased in value since you bought it. Otherwise you are drawing against its value like a second mortgage.
• the home equity line of credit provides approval for an agreed loan amount and you have the choice on how much and when you can use it. It is essentially a super credit card with the limit boosted by value of your house as security. The home equity line of credit is provided as a check book account or credit card with the approved amount transferred to the account. If you draw money from the account, you have to pay it back plus interest; if you don't draw against the funds, you generally won't pay anything, apart from an annual fee (in some cases).

How Does a Home Equity Loan compare with a Second Mortgage?

How Does a Home Equity Loan compare with Credit Card

A home equity loan is similar to a personal loan with a large credit limit backed by the value of your home. You can draw on the funds to get a lump-sum and pay it back in regular agreed monthly repayments over a specified period of time, usually 10 - 15 years or so. Usually there is a fixed rate of interest which is set at the time the loan is established.

A home equity line of credit, on the other hand, is more like a credit card. You sign up for a credit amount and you pay it back as you want plus the interest. After you secure a loan, you typically receive a credit card or check book. Whenever you draw funds from the account, you will then have a minimum payment to pay each month on your remaining balance, plus the interest. You determine when and how much you pay back, and the interest you will have to pay.

The interest rate may not be fixed but pegged to the variable rate, its generally less than that for a credit card, and perhaps for a personal loan, but more than for a mortgage.

What are the Pros and Benefits of Home Equity Loans and Lines of Credit?

• The most conspicuous benefit of a home equity loan is that its very flexible and is different from a personal loan which is for a exact purpose. The loan can be utilised for numerous things: for alleviating various liabilities, home renovations, buying a vehicle, funding a personal or financial crisis or getting money for education, a holiday or expanding a building.
• One other benefit is that the loan may be tax-deductible in some way. However, remember that the tax-deductible component is usually only a percentage, so if you happen to be in a higher earnings category it may provide very little benefit.
• The borrowings require smaller interest rates than credit cards and unsecured individual loans.
• They can be very appealing for retirees on reduced earnings who may find it hard to get a individual loan because of their age or reduced income. Retirees who are asset wealthy but earnings poor may find these loans very helpful for renovations, a vacation, health costs, a mobile home or a car.
• They generally offer a smaller interest rate than other borrowings and/or credit cards. The interest rates are often much smaller than for higher purchase deals, for example for buying a new car.
• The charges for getting a home equity line loan are somewhat lower than the alternatives.
• A home equity line of credit permits allows considerable flexibility for the borrowing and repayments since you are only required to repay the amount which you have borrowed. You decide how rapidly or slowly you pay it off.
• Home equity lines of borrowing permits you borrow what you need for short periods of time and mean that you do not require separate loans for many purposes.
• There are many advantages compared with a standard mortgage loans for which you have to pay a fixed allowance monthly. You only pay interest and you can pay-off large amounts without penalty. Over a time span of 10 to 20 years, it is likely that you will save numerous thousands of dollars in interest payments.

What are the Cons, Risks and Disadvantages of Home Equity Loans and Lines of Credit?

• The prime disadvantage of home equity borrowings is that they are essentially an added mortgage secured by your primary asset - your home; if you fail to make the payments, it places your dwelling at risk for foreclosure.
• Like any borrowing there may be a inclination to overspend and over commit yourself - and you may struggle to meet your repayments.
• Home equity borrowings are furthermore risky for persons facing vocation changes, because if your earnings drop, your dwelling could be at risk.
• If your home's value declines, you might end up with a liability that is greater than the value of your house, which can be disastrous if you are a retiree.
• The borrowings can be risky for retirees and older people who own their own home who may be devaluing their nest egg close to retirement.
• Credit lines have variable interest rates that could change and so monthly payments could increase, even if your earnings remain the same.
• Using a home equity loan to deal with debts may reduce monthly payments on credit cards, but could cost you more long term, because it will take longer to pay off the debt and the net interest payments will be higher in the long term.
• You may not be permitted to lease your dwelling throughout the period of your loan.
• Since these borrowings are essentially a second mortgage, the interest rate is higher than for a fixed-rate mortgage and the loan may be more costly to repay. Higher interest rates increases the monthly payments and this may change the net benefits for the loan compared with other options.

Are Home Equity Loans and Lines of Credit Right For You?

When concluding if a home equity loan facility is the right for you, address your long and short term objectives and do some cost benefit analysis. Home equity borrowings are good choices for those looking to borrow to value add and reap long-run rewards such as a home renovation or the consolidation of high interest rate credit cards or personal loans. In these case you are either adding worth to the dwelling or decreasing the cost of on-going debt repayment. But be very careful as the advantages may disappear if you fall behind with the repayments or your employment or other circumstances change.

Ultimately, you have to do some research and carefully consider your various options. Make sure you address all of the costs, benefits, risks and disadvantages, both short and long term. Your loan provider will be able to provide you with all the details for the various options you have to help you decide. Don't believe that a home equity borrowing will provide a quick fix without considering the risks and how your circumstances may change.

Beware: A home equity loan or line of credit is not suitable for every person and there are alternatives.

For example, it may make more sense to organise a cash-out refinancing option, or use a re-draw facility which adds to your mortgage, possibly decrease your overall repayment rate. You will get access to the difference between new mortgage and your one and in a lump sum. You should carefully examine all your options and their costs and benefits.

If you want extra money to pay off debt for a lifestyle you cannot afford then beware that you could lose your house or have your equity in it degraded.

If you're considering these loans as the tax break you needs to confirm the details and do a cost benefit analysis.

These loans should come with a big warning. You could save thousands of dollars, or you could end up in greater debt. It all depends on how controlled you are about using your money.

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