Home Sweet Loan? Five Things to Know About Home Equity Loans

By Markets Fool.com

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Borrowers are going home again to home equity loans, that is.

Shunned after the financial crisis, home equity loans have been making acomebackin recent years, as home values have rebounded and banks have reopened the lending spigot.

Total home equity loan originations reached $183 billion in 2015, an increase of nearly 50 percent from 2012, though originations remain far below the pre-crisis peak of $430 billion reached in 2006, according to trade publication Inside Mortgage Finance.

Home equity lending "has been growing briskly since 2013," said Inside Mortgage Finance's publisher, Guy Cecala. "Lenders have become more confident."

With a home equity loan, you borrow against the equity in your home, which is the value of the property, minus the mortgage. Homeowners will often use such loans to fund home improvement projects, pay for college or to pay off more expensive debts.

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But just because home equity loans are available, doesn't mean you should pounce. It's important to educate yourself before borrowing against your home.

Here are five things you should know about home equity loans:

There are two primary types of home equity loans

The first is a standard home equity loan. You borrow money in a lump sum and pay it back in fixed amounts over a specified period of time. Interest rates on standard home equity loans are often fixed.

The second and more common type of home equity loan is a home equity line of credit (HELOC). Here, a lender gives you a credit line and lets you draw down funds up to a maximum amount, functioning much like a credit card.

"It allows you the flexibility to borrow as needed," said Bruce McClary, a spokesman for National Foundation for Credit Counseling (NFCC).

HELOCs generally have a "draw period"often ten yearsduring which time you can borrow. After the draw period ends, the loan might have a "repayment period," a set period of time during which a borrower must repay the loan.

It's important to understand how repayment works. Some home equity loans allow borrowers to make interest-only payments during the draw period. When the repayment period kicks in,payments can surgeby hundreds or thousands of dollars a month.

In some cases, a borrower might be required to pay back the loan in one full lump sum after the draw period ends or otherwise refinance the loan or the loan and the existing mortgage together.

Also keep in mind, HELOCs generally have variable interest rates, tied to an index, such as the prime rate. That means your rate might fluctuate, and if the prime rate increases, so too will your HELOC interest rate. And small differences in an interest rate can really add up.

There are pros and cons to borrowing against your home

Like a mortgage, under certain circumstances, the interest on a home equity loan might be tax deductible. Check with a tax professional to see if your loan might be eligible.

Another potential advantage: rates on home equity loans tend to be lower than rates for unsecured loans, such as credit cards.

However, such loans also come with significant risks. When you take out a home equity loan, your property serves as collateral. That means if you find yourself unable to repay what you owe, you couldlose your home.

Separately, if the value of your home drops as happened across the U.S. during the housing crisis, you may find yourself borrowing against an asset that isn't worth as much as it once was.

Banks have stricter qualifications these days

In the years leading up to the financial crisis, banks rushed to offer risky home equity loans unmindful of the potential for widespread decline in property values, missed payments and foreclosures.

Today, banks have much more stringent underwriting requirements. Before the housing bubble burst, some lenders allowed borrowers to borrow against 100 percent of the equity in their homes. Now theceilingfor a home equity line of credit is generally around 80 percent, according to real estate research firm CoreLogic.

At the same time, banks are requiring higher credit scores. For instance, the average credit score at origination for a HELOC last year was 774, more than 30 points higher than in 2006, according to CoreLogic.

Consider the costs

The annual percentage rate (APR) of a home equity loan is just one of many costs you need to consider.

Depending on the type of loan you choose, there might be other fees and charges. There could be a property appraisal fee, an application fee, upfront charges (sometimes called points), attorneys' fees, and other types of closing costs. On top of that, you might have to pay annual membership and maintenance fees.

All in, depending on all these fees, you could end up paying hundreds of dollars to set up a home equity line of credit. If you were to draw down a small amount, these charges could substantially increase the cost of the funds you borrowed, theFederal Reservewarns.

Use home equity loans responsibly

Some people take out a home equity loan to pay off more expensive credit card debt. That could be a good thing. But remember you have now traded an unsecured debt for a debt secured by your home.

"Understand, you're now putting your home on the line," McClary said.

If you use a home equity loan to pay off your other debts, it's important to fight the urge to start racking up debts again, he added.

It can also be dangerous to use money from home equity loan to make a bet on the stock market or other type of investment. The Financial Industry Regulatory Authority (FINRA) haswarnedinvestors against using home equity loans to purchase securities.

Some individuals hope that the investment will not only pay the mortgage, it will generate additional income. But if those securities plunge in value, investors face the risk of failing to meet their home loan payments.

"Investors who bet the ranch could lose it," FINRA cautions.

The bottom line: Home equity loans, when used responsibly, could help you invest in home improvements, fund an education or help you get on a more sound financial footing. But you need to understand the costs, conditions and the risks.

Think about whether you can comfortably repay the loan and avoid the temptation to turn your home into a piggybank. Buying jewelry or going on fancy vacations won't give you much pleasure, if you lose your home in the process.

This article originally appeared on thealertinvestor.com.

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