If you have equity in your home, you may qualify for a home equity loan. But what is a home equity loan and should you get one? Here's what you need to know.
What Are Home Equity Loans?
To understand what a home equity loan is, first you must understand what home equity is. Many people who own a home have to take out a mortgage to purchase their home. Home equity is the difference between how much your home is worth minus how much you owe on your mortgage. If you run the calculation and the number is positive, you have equity in your home. As you make mortgage payments and slowly pay your mortgage off, your equity may increase, assuming your home doesn't drop in value. If the value of your home increases based on market conditions, then the growth adds to the equity in your home.
But even if your home is worth more than you owe on it, you can't just sell part of your home to access your home equity. Instead, if you have enough home equity and meet other requirements for a loan, lenders will let you borrow against that existing equity using a home equity loan.
What Can You Do with Proceeds from a Home Equity Loan?
You can use the proceeds from a home equity loan for almost anything you want. You could use a home equity loan as a way to pay for more expensive items you may not having savings to cover such as renovating your home, buying a new car, or helping pay for your child's college education. Alternatively, you could use the equity in your home to pay off high-interest rate loans. You could even take the proceeds and invest them in the stock market if you wish.
Benefits and Drawbacks of Home Equity Loans
Home equity loans, like all loans, have benefits and drawbacks. On the positive side, home equity loans often offer lower interest rates than many other types of debt. You also have flexibility when it comes to choosing the type of home equity loan that works for you. You can even use the money from your loan for whatever you wish. As an added benefit, the interest you pay on your home equity loan may be tax deductible.
On the negative side, home equity loans are secured by your home. If you can't pay the loan back, the lender can foreclose on your home. Unfortunately, home equity loans often have higher upfront costs than other types of loans you may take out. Another consideration is the total amount of interest you'll pay over the life of the loan. Although home equity loans can have lower interest rates than many types of loans, if you take fifteen years to pay the loan back, you may pay more in interest than other types of shorter term loans.
Different Types of Home Equity Loans
There are two main types of home equity loans, traditional home equity loans and home equity lines of credit. A traditional home equity loan allows you to borrow a fixed amount of money when you originally take out the loan. You pay it back over a fixed time frame. These types of loans usually come with fixed payments and fixed interest rates as well.
Home equity lines of credit work similar to a credit card. The bank sets a maximum loan amount and allows you to withdraw money until you reach that limit. Like with a credit card, you'll have monthly payments that change based on the amount of money you have borrowed and the interest rate, which is often variable.
Types of Home Equity Loan Interest Rates
Home equity loans can have fixed or variable interest rates depending on which type of loan you pick and which lender you choose. Fixed interest rates are set at the time you take out the loan and will not change. Variable interest rates can adjust over the life of the loan according to the details specified in your loan documents. Variable interest rates are usually based on an underlying interest rate, such as the one month LIBOR or the prime rate.
Shop for the Best Home Equity Loan for You
Now that you understand the answer to the question what is a home equity loan and should you get one, it's time to decide whether you feel a home equity loan would work for you. If you do decide to move forward and get a home equity loan, you should know it pays to shop around. Each lender will offer a home equity loan with different rates, closing costs and terms from their competitors. Finding the best home equity loan for you could save you hundreds or thousands of dollars over the life of the loan.