Types of Home Equity Loans - Help and Information on Home Equity Loans

Home Equity Loan Types

There are two types of home equity loans. The standard home equity loan and a home equity line of credit. However, another way of borrowing against home's equity is with cash-out refinancing.

The Standard Home Equity Loan

With a standard home equity loan, the money is loaned in one lump sum and is repaid at a fixed interest rate by monthly payments over the duration of the loan.

The length or term of a home equity loan is shorter than your first mortgage on a home. The term on a home equity loan can be from 3 to 15 years whereas a first mortgage typicaly runs from 15 to 30 years.

It is usualy recommended that you take the shortest term possible that still allows you to easily make your monthly payments. This is because of the mountain of interest you will save. Let's compare two home equity loans each for $30,000 at 7.5% - one has a term of 10 years and the other has a term of 20 years. If you can pay back the money in 10 years instead of 20, you will save more than $15,000 in interest which is more than half of what you are borrowing.

The interest rates of a home equity loan are higher than that of a mortgage. This is because home equity lenders take on a greater risk than a mortgage lender. If your house must be sold, the lender of the first mortgage gets paid before the lender of a second mortgage or home equity loan.

With both home equity loans and lines of credit, you must pay off the loan in full if the home is sold.

Home Equity Lines of Credit

A home equity line of credit works very much like a credit card that is guaranteed by your home. You have a limit or a maximum amount that you can borrow against as the need arises. Your payments will depend on the amount of money you use and a variable interest rate.

Home equity lines of credit often offer an introductory low interest rate. The introductory rate is a very low interest rate that is offered for a short time at the beginning of a loan. After the introductory period, your interest rate will increase by several percentage points.

The interest rate you pay on a home equity line of credit is calculated using an underlying index rate and then adding a margin rate to it. Commonly the index that is used is the prime rate . The margin that you pay is a certain number of percentage points above the index rate. For example, if the current prime rate is 5% and your margin is 1%, you pay a 6% interest rate on your home equity line of credit.

The interest rate on a home equity line of credit is usually a variable rate although fixed interest rates is a possibility with some lenders. Some lenders may even allow you to convert from a variable interest rate to a fixed rate during the loan period or even convert all or some of your home equity line of credit to a term loan. If this option interests you, ask the lender if this is available and ask about what costs may be associated with this option.

In a variable interest rate loan, the way that the interest rate changes is decided by the periodic cap and the lifetime cap. The periodic cap is the limit on interest rate changes at one particular time. The lifetime cap is the limit on interest rate changes throughout the duration of the loan.

The duration of a home equity line of credit is called a draw period. This is the period of time in which you have access to the funds. When you borrowed money from your home equity line of credit, your monthly payments will vary with the variable interest rate and the total amount borrowed which is referred to as the outstanding balance. You can pay the outstanding balance in full or you can make a minimum payment on the balance. You should know that some plans may demand that you keep a minimum amount outstanding. Ask if your plan does or not.

If you have an outstanding balance at the end of the draw period, it may be required that you to pay the outstanding balance in full. This is referred to as a 'balloon' payment. You may have the option of repaying the outstanding balance in payments over a set period of time. This second option takes the outstanding balance of a home equity line of credit and turns it in to a term loan. You must ask about what happens to an outstanding debt at the end of the duration of a home equity line of credit before you sign the loan documents and close the deal.

Home equity lines of credit can be structured differently. Here are some features that you should know about. Home equity lines of credit may require you to draw an initial amount out when the credit line is opened . Your credit line may have a transaction fee each time you use money from it and you may be subject to a minimum or maximum withdrawal amount each time money taken out. Some lenders may waive closing costs if you keep the minimum withdrawal amount outstanding for a period of about six months. When the draw period expires, you may or may not be able to renew your line of credit.

Continuing costs, which are also called annual membership or participation fees, are yearly fees that are charged to maintain the home equity line of credit. Continuing costs are applied whether or not you use your line of credit. Inactivity fees are fees that are charged if the account remains inactive over a certain period of time. Be aware that you may be charged continuing costs and/or inactivity fees.

With both home equity loans and lines of credit, you must pay off the loan in full if the home is sold.

Cash-out Refinancing

Cash-out refinancing lets you access equity in your home by taking out a new mortgage that is greater than your old mortgage. The new mortgage is used to pay off your old mortgage and the difference between the two in effect is your home equity loan.

Since you are replacing your first mortgage with a new mortgage, cash-out refinancing is only viable when the refinancing interest rate available to you is lower than your current mortgage. The lower interest rate in refinancing will lower your monthly payments on your mortgage. Because of the closing costs associated with refinancing, you should only refinance your home if the savings on your lower monthly payments can recover the closing costs before you sell your home.

Lets assume your closing costs for refinancing were $3,000 and that the refinancing deal gives you a lower interest rate that lowers your monthly mortgage payments by $150. This means that you must not sell your home for at least 20 months to recover the refinancing costs ($20 months * $150 a month in savings = $3,000 refinancing cost). After that period, you have recovered your costs and you are now saving money.

Since cash-out refinancing is a first mortgage, it usually has a lower interest rate than a home equity loan which is also known as a second mortgage. Cash-out refinancing takes longer to process than would a home equity loan.

If cash-out refinancing raises your loan-to-value (LTV) ratio above 80%, you will be required to pay (PMI) private mortgage insurance. PMI protects the lender if you default on your loan. PMI is not for you. PMI costs should be considered when cash-out refinancing has an LTV that is more than 80%.

When you are thinking about cash-out refinancing, ask about escrow services. The loan's monthly payments may include an escrow amount for property taxes and homeowners insurance. If an escrow amount is not included, you will have to budget for those costs separately.

While the cash-out refinancing is generally available to any homeowner that has equity in their home, your first mortgage may have a prepayment penalty clause that does not make refinancing a good option.