Home equity loans have become widely used within the past 10 years, as adults struggle to pay the rising costs for their children's tuition and their retired parents' health care. BankRate.com explains a home equity loan as a loan where the equity in a person's home is pledged as collateral in exchange for money. Equity is simply the different between the home's value and what the homeowner owes on the property.
Types of Home Equity Loans
There is not one standard loan used for all home equity loans. Rather, there are several different types of home equity loans. According to BankRate.com, a traditional home equity loan involves a one-time lump sum of money loaned to the homeowner, which is paid off month by month. A HELOC, or home equity line of credit is a type of revolving home equity loan where the homeowner is allowed to take several different draws of the loan money when he needs it, up to a maximum amount of borrowed money established in the contract.
Purpose
The main purpose of home equity loans is to give the homeowner cash to do what she needs to do. There are several common reasons why people take out home equity loans. Tuition and medical bills are among the most common reasons. Home improvements, such as adding in a pool or redoing the kitchen, are another reason why people get home equity loans.
Drawbacks
One drawback to home equity loans is the fact that they are not considered to be purchase money, since they are taken out when the homeowner is already in the home. This means that they are a type of recourse debt, where if the borrower defaults, the lender can come after the borrower's other assets and even garnish wages. The Federal Reserve Board states that if you sell the home before paying off all of the payments from the home equity loan, you will be required to pay the home equity loan in full right away.
Truth in Lending Act
According to the Federal Reserve Board, the Truth in Lending Act requires that all lenders disclose the financial terms of the loan before a borrower decides to take out a home equity loan. The lender must disclose the annual percentage rate, type of interest, amount of interest and several other factors. The purpose of this act is to protect homeowners.
Costs
The interest rates from home equity loans can end up costing a lot of money over time. BankRate.com explains that in addition to paying a fixed or variable interest rate on the home equity loan, a borrower must also pay closing costs like he did with his original home loan. There may also be points and loan origination fees to pay. Since the loan depends on the amount of equity in the house, the homeowner will probably have to pay for a home appraisal before getting a home equity loan.
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