How does a home equity line of credit work

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One of the easiest loans to qualify for is a home equity loan but there are not always easy to understand. So how does a home equity line of credit work? When you take out one of these loans, you are borrowing against the excess value of your home versus what you owe on it. Of course it goes without saying that your home must be worth more than you owe on it to take out a home equity loan.

Obtaining a home equity loan is not risk free either. It’s essentially taking out a second mortgage and putting your home up as collateral. It can however be a great way to come up with the large amount of extra cash you need. And that is especially true if you have built up enough equity in your home.

The Benefits Home Equity Loans Give You

Here are some of the key benefits of home equity loans:

  • Lower Interest Rates

The fact that you get a secured loan (meaning that you borrowed against your house) highly reduces the risk of default. The lenders will be able to lend you money at a lower rate because of this.

  • Easier Approval

Once again, since you are putting up collateral it may be an easier type of loan to get if you have poor credit. That does not mean you won’t need extensive documentation to get your home equity loan approved. There is still a set criterion for loan approval also. It’s not automatic.

  • Larger Loan Amounts

Borrowers tend to qualify for larger loan amounts with this type of loan. That’s if you have enough equity on your home of course. It can even be enough to do such things as fund college tuition or start a small business.

  • The Chance for Some Tax Benefits

In some cases a portion of the interest you pay on your home can be deducted from your taxes. This is particularly true if you use your home equity loan for home improvements.

READ MORE>> Learn anything you want to know about home equity line of credit requirements 

Home equity line of credit rates

Since it’s a secured type loan you are more likely to get a lower interest rate on it than if you took out an unsecured loan. Closing costs can cut into this savings though. Moreover, there are reasons why home equity loans are easier to get even for those with poor credit. That’s again, because lenders feel safer when they have your house as collateral. Failure to pay means the bank can actually take your property from you. This is done by foreclosure on your home. Since borrowers know this, they also tend to prioritize these types of loan payments too.

Approval isn’t 100% guaranteed

Of course having a large amount of equity in your home is a good place to start in obtaining a home equity loan but it’s not a guarantee for approval. This is especially true since the housing crisis in 2007 made homes harder to sell. Lenders will now only lend you up to 80% of the equity in your home.

No matter how much equity you have in your home, your lending institution must also be convinced you have the ability and will to make your loan payments.

FIND OUT ABOUT>> Personal loan apps, a review of apps for loans up to $30,000 in case you need extra cash and don’t want to take home equity loan

What is the difference between a home equity loan and a home equity line of credit

There are basically two types of home equity loans you can apply for, a lump-sum loan or a heloc (home equity line of credit).

Lump-sum home equity loan

This is when you take the total amount of the home equity loan you are approved for all at once. It then has a set interest rate that will remain the same for the life of the equity loan. Your payments cover some of the loan and interest on the loan (called an amortizing loan).

What is a HELOC and how does it work

This is where you know how much your home equity loan is approved for but you have chosen to not take it out all at once. This is also known as a home equity line of credit.  This type of loan lets you make smaller payments in the first few years of it but at some point full payments must start taking place.

This is a flexible option because it gives you some say over your interest costs and loan repayments because you control the balance on the loan. There are cases where a lender may freeze or cancel your line of credit if they feel the loan is not being used. So there is some risk that comes with its flexibility. Interest rates can change for the worse over time too.

Steps to get a Home Equity Loan

  1. Get some loan estimates from various sources to find your best rate. Try using:
  • Banks
  • Credit unions
  • Online lenders
  • National lenders

Do this because interest rates and other payment terms can vary widely between different sources.

  1. Get your paperwork together

When you apply for a loan the lender will want to check such things as your credit history and will also require you to get a get a home appraisal. It may take several weeks to get approved and get your loan money. The lender will also need to see pay stubs and other proof of income if you have other income sources besides work.

  1. Know the Repayment Terms

Before you take out any home equity loan make sure you are familiar with the payment terms and interest rates. Be aware of any hidden penalties that may raise the cost of the loan too. These include late payments, early loan payoff charges and more.

Typical Uses for Home Equity Loans

There are no hard and fast rules that say what you can and can’t use your home equity loan to pay for. These are some of the things that home equity loans are commonly used for.

  • Remodeling, renovations and home improvements
  • College tuition payments
  • Buy land or a second home
  • Debt consolidation/High interest debt payoff

Home Equity Loan potential Risks

As with any good thing home equity loans do carry some risk. One of the biggest risks include possibly losing your home if you fail to make timely loan repayments.

Here are some other significant risks associated with home equity loans:

  • Significant debt accumulation

People have a tendency when they get a large sum of money to spend it needlessly and rack up even more long term debt on top of their existing debt. That’s why professionals recommend when you take out a home equity loan that you use it to add value to your home or for a means such as debt consolidation that will save you money in the long run. You must always determine if your home equity loan will result in “good” debt or “bad” debt.

  • Fees can add up quickly

If you are not careful, the fees for using your home equity loan can add up quickly depending on how your loan is set up. Make sure you to take into account the fees to assess whether it is worth it to take out a home equity loan.

How to shop for the best home equity loan

It is surprising how many people do not take the time to shop around for a home equity loan. If you take the time to look at different home equity loan options it can actually save you thousands of dollars over the life of your loan.

Here are the keys to success when shopping for a home equity loan:

  • Shop around

Don’t just look at one or two home equity line sources. Check online lenders, banks, credits unions and specialized lending services for the best deal.

  • Stay on top of your credit score

Your present credit rating is important in order to get a home equity loan approved. Obtain a copy of your credit report and make sure the information in it is accurate. Do what is known as rapid rescoring to quickly improve your credit score and get a better loan rate.

  • Network

Don’t be afraid to ask your family members and close friends who they used to get their home equity loan and how the experience was. Real estate agents often know who the best loan originators are in your area too.

  • Compare loan estimates

Get some actual loan estimates from the lenders you are thinking about using and then you can do some comparison shopping.

Additional Home Equity Loan Tips

We hope we were able to help you figure out how does a home equity line of credit work. Here are a few tips for making sure a home equity or line of credit is the right move for you at this time:

  • Is it the right loan for the situation?

Before you sign on the dotted line make sure your home equity loan makes sense for what you are trying to do. Sometimes a simple credit card account or an unsecured loan will fit your needs better. Sometimes it’s just not right putting your home at risk.

  • Make a revised budget

Another thing you want to do before you sign for your new home equity loan is make double sure it fits in your budget. You can do this by including the new loan payment in your budget and see if you are still comfortable with it.

  • Consider your current insurances

You need some contingency plans for loan repayment just in case the unexpected happens. You should have proper disability and life insurance coverages in place when you take out your loan.

  • Find out how your home equity loan affects your taxes

It used to be that interest paid on home equity loans was tax deductible. Find out from your CPA how your home equity loan will affect you tax wise.

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How does a home equity line of credit work
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How does a home equity line of credit work
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One of the easiest loans to qualify for is a home equity loan. But there are not always easy to understand. So how does a home equity line of credit work? When you take out one of these loans you are borrowing against the excess value of your home versus what you owe on it.
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Brianna Sass