How Does a Home Equity Loan Work?

Home equity loans provide a source of money to pay for a wide range of products and services using the borrower's home equity as security. Like the original mortgage, a home equity loan (or second mortgage) represents a fixed amount of money repaid over a fixed term. Lenders calculate the total amount you can borrow, typically capped at 85 percent of the equity in the home used as security. The actual amount is calculated based on the borrower's credit history, current income, and the home's current market value. Terms typically run from five to 15 years.

Not All Home Equity Loan Offers Are the Same

Home equity loans are based on the difference between how much the consumer owes on the home mortgage and the current valuation of the property. Beyond that, there can be fees and charges that distinguish loan offers. According to the Federal Trade Commission( FTC), borrowers can benefit from comparing home equity products based on variables such as application and processing fees, appraisal fees, title insurance, underwriting fees, broker fees and other charges commonly assessed as points (or incremental rate additions) on each lender's offer.

At the same time, lenders may reduce percentage rates or closing costs if the borrower has outstanding credit history and poses a relatively low risk. Lenders have plenty of flexibility and power when it comes to tailoring a loan offer to the credit-worthiness of the borrower. Consequently, shopping competitive offers can make the difference in how much the consumer ultimately pays for a home equity loan.

The bottom line is that negotiating the rate is common, and even if you sign the loan documents and get cold feet, the loan can be cancelled within three business days under federal law if the borrower is using their principal residence as security on the loan. The lender then has 30 days to return all funds and fees paid toward the loan.

Wide Uses for Home Equity Loans

Consumers find few restrictions on the expenditure of home equity proceeds. Common uses include:

  • Debt consolidation (credit card balances)
  • Home improvements
  • College tuition
  • Medical expenses

Interest payments on second mortgages can be tax deductible (talk with your financial counselor), which means consumers can consolidate debt and improve the value of their home with one home equity loan product.

Since the second mortgage is paid monthly in addition to the original home loan, consumers need to be especially forthcoming about their ability to afford their debt payments. Remember: If you default on the home equity loan, you lose your house.

Warning: Unscrupulous Lenders

According to the FTC, there are unscrupulous lenders who prey on the elderly, persons with poor credit or low income. Questionable strategies include making offers to refinance or flip the loans frequently, increasing total debt under the ruse of getting consumers a better deal. It recommends that homeowners avoid potential lenders unwilling to provide complete disclosures on the loan amount, the rate, and the terms and conditions attached to the new mortgage. Do not necessarily agree to insurance charges not commonly required on second mortgages. And last, check for any penalties for early loan repayment or stipulations for a whopping balloon payment at the end.

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