5 Things to Know About Home Equity Loans

By Christy Bieber Markets Fool.com

As your home rises in value and you pay down your mortgage, you'll build substantial equity in it. While having equity is a good thing, it also means you have a lot of trapped money that you may want to put toward other uses, like paying off debt or financing a home improvement project.

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The good news is you can tap into your home equity by taking a home equity loan or opening up a home equity line of credit (HELOC). The bad news is you'll pay interest on the loan, and there are risks associated with taking equity out of your house. If you have a pressing financial need, it could make sense to accept those risks -- but be sure you know exactly what you're getting into.

These five facts will help you make the right decision about whether a home equity loan or HELOC is right for you.

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1. You must have enough equity in your home to qualify for the loan

You should have equity in your home to protect both you and the bank. If your home is worth $200,000 and you borrow $200,000, you could have a difficult time selling the house for a price high enough to pay off the loan, especially if property values fall. If the bank had to foreclose, the sale might not generate enough to repay all costs. This is true when you first take a mortgage and when you tap into your home's equity.

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Whether you take a home equity loan or a home equity line of credit, the bank you approach will determine your combined loan-to-value ratio by adding the amount of the first loan and the new loanand dividing the total by the value of your home.Most banks won't issue a home equity loan unless your combined loan-to-value ratio would be around 80% or less, although some banks allow you to borrow up to 95% of the value of your home if you have good credit and a history of on-time payments. Expect to pay more for a loan with a higher loan-to-value ratio.

2. You have a choice between a home equity loan and a home equity line of credit

If you want to take the equity out of your home, you can structure your borrowing in two ways.

One option is a home equity loan. This works similarly to a traditional mortgage. You borrow a set amount of money, usually at a fixed rate, that you'll repay over a designated period of time -- usually five to 15 years.

Another alternative is a home equity line of credit (HELOC). A HELOC allows you to borrow up to a certain amount of money -- say, $10,000 -- at a variable rate over a designated time. However, you don't have to borrow the full amount all at once. The HELOC works similarly to a credit card, but at a much lower interest rate, because your house serves as collateral. You can borrow as needed, up to the maximum, and you'll pay back what you've borrowed as you go.

HELOCs usually have variable rates, and you may have to pay a balloon payment at the end if you have outstanding debt. If you had a $10,000 line of credit and borrowed a total of $8,000, you'd have to pay the full $8,000 when the line of credit expired. Some mortgage lenders allow you to renew, but not all do. You benefit from the flexibility of not having to borrow the full amount at once, but you assume the risk that interest rates will rise or that you'll get stuck with a big payment in the end.

3. Mortgage interest should be tax-deductible

One big benefit of both home equity loans and home equity lines of credit is the tax deductibility of loan interest. You can deduct interest on a loan up to $100,000 if you're married filing jointly, or $50,000 if you're single or married filing separately.

Deducting your loan interest could save you thousands of dollars, but you must itemize your deductions in order to claim that tax break -- and only around 30% of households itemize. Before tax time comes around, you'll want to figure out whether itemizing or taking the standard deduction will save you more money.

4. Home equity loans are usually higher-rate loans than mortgage loans

While home equity loans and home equity lines of credit have much lower interest rates than credit cards, their rates are generally higher than those on a first mortgage.

Home equity loans and HELOCs are considered second mortgages, and your primary lender has first claim on your house. If the home was foreclosed on and sold for less than the combined balance of your first and second mortgages, the first mortgage lender would be paid in full and the second mortgage lender would come up short. The higher risk of not getting paid justifies a higher rate.

The difference can be substantial. The interest rate on a 30-year fixed rate mortgage is around4% as of this writing, but the interest rate on a home equity loan is5.21%, and the interest rate on a home equity line of credit is5.45%. So be prepared to pay more for the privilege of tapping into your equity.

5. There are some risks to taking a home equity loan

Borrowing against your home can make sense if you have big credit card debts to repay or other financial goals at a low interest rate. But there are big risks to home equity loans and HELOCs.

If you take too much equity out of your home, you could find yourself underwater -- i.e., owing more than the house is worth -- if your home loses value. In that case, you won't be able to sell without bringing cash to the table. And if you find yourself in financial trouble and unable to pay back the second mortgage, you could lose your house.

Be sure you can actually make the payments for the life of the loan and ask yourself whether you want to put your home at risk for whatever it is you're borrowing for.

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