The Basics of Home Equity Loans. Help and Information on Home Equity Loans

The Basics of a Home Equity Loan

What is a home equity loan?
A home equity loan is a loan that uses your home as collateral. Your home equity is the part of your home that you have paid for (capital) and actually own and this is used as the guarantee for your loan.

Your home equity is calculated by taking the current value of your home and subtracting the outstanding balance of your mortgage. For example, if your home is worth $250, 000 and you have a $200,000 mortgage balance, you have $50,000 of equity in your home. A home equity loan allows you to borrow money using your equity of $50,000 as security for the loan.

A home equity loan, also called a second mortgage, reduces your equity or ownership in your home. Never forget that since your home guarantees your loan, if you default on the payments, you could lose your home.

The advantages and disadvantages of a home equity loan.
A lower interest rate and tax deductions are two of the advantages that home equity loans have over other types of debt.

Since a home equity loan is secured by your home, it presents less risk to a lender than non-secured personal loans or credit cards. This lower risk is passed on to you as a lower interest rate.

The second advantage is that regardless of the way a home equity loan is used, the interest you pay on the first $100,000 you borrow is tax deductible. Credit cards and other types of non-secured loans don't have this tax advantage. This means that if you pay $4,000 in interest on your home equity loan, you will be reducing your taxable income by $4,000 at the end of the year. If you use a home equity loan for home improvements or to buy another home, you may deduct the interest paid on the first $1 million that you borrow. This is because home improvement loans are similar to first mortgages in regards to tax purposes. You should consult a tax advisor about the specific tax benefits that are available to you.

The biggest drawback of a home equity loan is that you could lose your home if you default on your payments. When you borrow from your home's equity you also reduce the equity or ownership you have in your home. This means that you trade ownership or equity in your home for cash that you will use for some something else. On top of the interest you will pay on the loan, there are also other costs when taking out a home equity loan. These costs are similar to the costs you paid when you first bought your home.

What can Home Equity Loans be used for?

A home equity loan can be used for anything from buying a car, to paying off high-interest credit card debt as well as to home improvements to buying. The best uses of a home equity loan are to improve your financial situation, improve your home or your future. These include debt consolidation, home improvement and education. Your money is invested in something that grows. Poor uses of a home equity loan are to pay for living expenses or to buy a car meaning that the money is spent on something that depreciates over time or does not create an asset.

Here are some of the popular uses of home equity loans:

Debt Consolidation
Using home equity loans to replace various credit cards and other high-interest debt have several advantages. The interest rate you pay on your average home equity loan is lower than the interest rate you will pay on your average credit card by 7% - 10% or sometimnes more. The interest you pay on a home equity loan is tax deductible whereas the interest you pay on credit cards is not. A single payment on a home equity loan can simplify paying off several credit cards with different lenders and staggered payment dates.

Let's assume you have $20,000 in credit card debt at 18%. If you are making payments of $450 per month (50% more than the minimum payment of $300), it will take you over 6 years to pay off the debt and you will end up paying $13,045 in interest. Using a home equity loan at 8%, making the same payment you can pay off that debt in 4 years and 4 months and pay only $3,732 in interest. This means that you have just saved over $9,000 in interest. Also, with this scenario, if you are in a 30% tax bracket, you will also save over $1,000 in taxes on the $3,732 you will pay in interest.

A home equity loan can also help make unmanageble credit card debt manageable by spreading out the payments over a longer period of time. If a home equity loan is used for this reason, you must consider the fact that you may be paying more in interest in the long run if you make smaller payments.

When a home equity loan is used for debt consolidation, you should have a plan for how you will avoid adding more debt.

Home Improvements
A home equity loan that is used for home improvements, repairs and/or upgrades, can give you a tax sheltered way of increasing the value of your home.

If you make home improvements with the intent of increasing the value of your property, (as opposed to making it a more comfortable place to live in), make sure that the renovations will add the value you are intending. For example, renovating a kitchen may recover the money spent and sometimes more, but adding a pool may not.

In most cases, a home equity loan decreases your home equity, however, when used for home improvements, a home equity loan can increase your home equity by increasing its market value beyond the value of the loan.

Higher Education
A home equity loan could be invested in your future by paying for your education. A higher paying job and a brighter future makes the invested money pay for itself. The money could also be used to pay for your children's education if you do not qualify for low interest government loans. A home equity loan used to pay for your child's higher education can be structured in a way that you pay only the interest while he or she is in school with the hope that the balance of the loan will be paid by the graduate.

Major Purchases
You shouldn't use a home equity loan to buy a boat, a car, go on vacation or buy some other luxury item. It is better to save until you can afford those. The problem is that you increase your debt and decrease your home equity to buy these items that only depreciate over time. However, using a home equity loan to buy a car would make the interest paid tax deductible where as the interest paid on a standard car loan is not.

Investments / Business
A home equity loan can be used to start a business or or investment fund that can also be used for investing in other properties or even the stock market. We advise caution when using the money for these purposes. While these can certainly be profitable and succeed, they carry a great risk and it could cost you your home.

Lenders will always ask what you want the home equity loan for. You should know that some lenders will not give out home equity loans for business and investment purposes as they think that this is too risky.

Living Expenses
A home equity loan should not be used to pay for living expenses. If you are spending more money than you make, and you need a home equity loan , it is a very bad sign. Funding living expenses could easily cost you your home.

Miscellaneous
Home equity loans can be used for anything. Some less common uses include emergencies, paying for medical treatments or helping out a family member in need.

Home much can I borrow in a Home Equity Loan?

Home equity lenders usualy allow you to borrow from your home equity until you reach a loan-to-value (LTV) ratio of 80%. The loan-to-value ratio is the total money that you have borrowed divided by the value of your home.

If your home is worth a $200,000 and you have a $120,000 mortgage, your LTV is 60%. If you then take out a home equity loan for $40,000, your LTV will rise to 80%. Lenders usualy allow the combined value of your first mortgage and your home equity loan to be 80% of your home's value but some lenders do allow higher LTV's. Some lenders will allow LTV's to go as high as 125%. There is of course a catch to this. Higher LTV loans will cost you more since they have a greater degree of risk to the lender.