An introduction to home equity loans
What is this financial instrument known as a 'home equity loan'? When it comes down to it, it's just a way of using your house as security to borrow some money. Borrowing with your home as security, rather than taking out an unsecured loan, often enables you to get a better rate, or it might give you access to lenders who would not consider giving you an unsecured loan.
Some home equity loan issues to consider
Shopping for a home equity loan brings with it much of the complexity of shopping for a first mortgage. You'll have to think about the interest rate. Would you rather have a 'fixed rate' home equity loan - where the amount you will have to pay is more predictable, but will on average be slightly higher than otherwise. Or will you take the risk of a variable-rate home equity loan, sacrificing certain knowledge of what you will pay in return for getting a potentially more competitive, index-linked rate. Would you like an 'interest-only' home equity loan, where your monthly payments will only cover the interest, not reducing the amount of money tied up in the principal?
The decisions may be similar to those you face with a first mortgage, but the pressures and reasons to lean in one direction or the other are slightly different. For one thing, the amounts tied up in second mortgages (home equity loans) are typically smaller than in first mortgages. The upshot of that is that you don't need to worry quite so much about facing financial catastrophe if the interest rate rises - because of the smaller size of the home equity loan, you'd likely be facing mere belt-tightening rather than outright bankruptcy.
How home equity loans compare to the alternatives
Some US residents will be comparing taking out a home equity loan vs. borrowing from the their 401(k) retirement plan. This kind of choice can become very complicated to analyze - the tax, situation, in particular, can be hard to interpret. So I won't say any more than that the option of the home equity loan is well in the running - but here is the calculation you'll have to make. Work out the cost of taking out a home equity loan for the amount that you need to borrow, not forgetting to take tax into account. Then work out how much that amount of money would earn you, if you were to leave it in your 401K. If the cost of the home equity loan is lower than the amount you would earn by leaving the money in your 401K, then you're better off taking out a home equity loan. Otherwise, take the money out of your 401K - since it's your money anyway, you don't have the same problems with approval as you would taking out an unsecured loan.
How to buy a home equity loan
Many organizations will try to sell you a home equity loan. Some of them are responsible and considerate, others simply want to take your money. You can't immediately tell which is which, and certainly not from appearance alone. The nice man in the smart suit might just be a crook who's a good salesman. The dingy back-office might be the place that can give you the best deal. Since you don't know who you can trust, your only solution is to trust nobody. Don't worry about who they are, just worry about the kinds of home equity loan that they offer.
As with mortgages, using the internet to shop for home equity loans enables you to compare rates and conditions much more easily. There exist various sites which will compile lists of the rates offered by the major lenders, but to get full details of the strings attached to those rates you'll need to look at the sites of each individual lender.
But even with the benefits of the internet, comparision-shopping for home equity loans is a tricky business. Bear in mind the difficulty of finding a single rate to compare across multiple lenders. The rate offered by a lender for any home equity loan will depend on what niche you fall into, since depending on your financial circumstances you will qualify for differing conditions and interest rates. You need to force each lender to be very precise about their terms and conditions, in order to be able to compare their prices to those of other home equity lenders.
So unless the thrill and complexity of finding your own home equity loan appeals to you, it might be in your best interests to use a broker. Many mortgage brokers will also handle home equity loans, and they will have a good understanding of the main players in your section of the marketplace, and of how to get you the best deal. Naturally you still need to talk to your broker, and to ensure that he or she is working in your best interests rather than to maximise commission or kickbacks - but brokers know that their reputation relies on their ability to look after their customers. That, combined with an admittedly fairly basic state licensing system, helps keep home equity loan brokers honest.
What can go wrong?
A home equity loan is like a mortgage, in that if you fail to keep up repayments then your home will be repossessed. This means that arranging a home equity loan is a very serious business, and one that you shouldn't enter into without the greatest of care and preparation. Don't buy a home equity loan unless you are absolutely certain that you can repay it, because being evicted from your home is one of the most unpleasant experiences there is.
All other risks of a home equity loan pale in comparison to that. Yes, you might get a bad rate that will leave you out of pocket. But under most circumstances you will have some option to refinance or change conditions, possibly by combining your first mortgage with your home equity loan (the second mortgage) into one package.
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