How Does a Home Equity Loan Work and
What Is Home Equity Best Used For?

If you own a home and you have equity in the property, you have financial options available that you can utilize by taking out a home equity loan or a home equity line of credit. These types of loans allow you to borrow money for major expenses. If you are considering borrowing equity from your property with a home equity loan or a home equity line of credit, it is important to understand the advantages and disadvantages of both:

Advantages:

• You get a lump sum of cash to use how you wish.
• Low fixed home equity loan rate.
• Tax deductible interest on home equity loans in most cases

Disadvantages:

• You pay interest on the entire sum of money you are borrowing from the start.
• Getting a large sum of money takes strong financial discipline.

This type of loan allows you to borrow a lump sum of equity from your home and pay it back over a fixed period of time and at a fixed interest rate – just like a first mortgage or a car loan. A home equity loan program makes sense if you know you need to borrow a large amount of money at once for a major expense. For example, if you need to pay for a year of college education at once, a home equity loan of $25,000 could be a good choice. Typically banks and lending companies require high fico scores, but there are a few lenders in our network that offer home equity loans with bad credit.

A home equity loan can be a good option, but you also should know about the other major choice to tap home equity:

How a Home Equity Line of Credit Works

This is a different type of loan than a home equity line of credit (HELOC). The latter works very much like a credit card. That is, the 2nd mortgage lender makes a certain amount of credit available based upon the equity in your home. The line of credit is available as you need it over a certain term, such as five or 10 years. The repayment period can be up to 20 years, and the rate is adjustable with market fluctuations.

A HELOC credit line could be the choice for you if you need to borrow smaller amounts over a longer period. If, for example, you need funds to pay for a home renovation project, you might get a HELOC of $25,000 and draw it over time as it is needed.

Advantages:

• With a HELOC loan, you only pay interest on the portion of the credit line that you are using.
• You can draw the money out over time as you need it.

Disadvantages:

• The interest rate on the HELOC can vary with the market.
• Lenders can withdraw your line of credit if your financial situation changes or your home's value drops. A HELOC may not always be there when you need it.
• Most HELOCs have a low, interest only payment for the first 10 years. After that, the line of credit closes and the principal must be paid back, which increases payments.

How to Use a Home Equity Loan or Home Equity Line of Credit

During the housing bubble from 2000-2007, some consumers tapped their home equity to pay for everything from vacations to car to kitchen renovations. Some also used these loans to cut their credit card debt. The theory there was to get rid of high interest debt and pay off debt at a much lower interest rate.

These spending habits relied upon home values continuing to rise. When the market crashed, their homes were worth much less than they paid for them. Many people lost their homes.

So, when you are thinking about a home equity loan or line of credit, you should carefully consider if it is a smart use of your home equity. With those thoughts in mind, experts currently consider these uses of home equity to be either a good or bad idea:

Good Idea

• Use home equity to cut high interest debt. This CAN make sense if you pay off high interest credit cards at 15-20% interest with a 4% or less home equity loan. However, you have to stop running up high interest credit card debt.
• Use home equity to pay for an essential home repair, such as a leaking roof or a serious foundation problem. These are repairs that are going to tank your home's value, so you can make a strong argument here.
• Paying for college education, in some circumstances. You must look at what the interest rates are for education loans. If you have to borrow money from some source to pay for your child's college education, we think that the college experience should be kept as affordable as possible. Perhaps the child can live at home and go to school; this can reduce the cost of college by 50%.

Bad Idea

• Buying a car. A car is a depreciating asset, and if you have good credit, you can get many car loans for nearly zero percent interest.
• Investing in real estate. If the investments go south, you may be unable to pay your mortgage.
• Taking a vacation. A vacation may leave you with great memories, but borrowing money from your primary residence to take a trip is foolish.
• Some home improvements. Some homeowners assume that any home improvement will pay off when you sell. This is not the case. For every $100 you spend, you might get $70 back.

Borrowing equity from your home with a home equity loan or line of credit can make sense, but you have to carefully look at why you are borrowing the money before pulling the trigger.