How Home Equity Credit Works

Home owners often choose to borrow against equity held in their property for reasons such as debt consolidation, home improvements, financing a college education or simply for spending. Many are tempted to use home equity credit as the appraised value of their property rises, and borrow against it even though the initial mortgage is still outstanding. Home equity credit is relatively easy to obtain as the home is held as collateral against the debt.

There are two different types of home equity credit. The first is a straightforward home equity loan, whereby the home owner takes a loan with a fixed repayment schedule on a fixed interest rate. Terms will be dependent on the lender. Although the interest rates will be lower than those available on an unsecured loan, borrowers should give consideration to the applicable fees and legal costs involved. Any loan taken against the home is risky as it increases the chance of losing it if default occurs.

The second common type of home equity credit is the HELOC. This is a home equity line of credit and has distinct differences to a home equity loan. The homeowner is extended a line of credit with a credit limit, and may draw up to the limit to service borrowing requirements, generally accessing the credit line by checks or credit cards. If the line of credit is for instance 20,000 dollars there is no necessity to borrow the full amount, though a minimum amount is usually determined by the lender.

There are no set monthly repayments, just a set period of time when the line of credit may be utilized with a set date to be repaid. Borrowers are only charged interest on the amount they borrow rather than the total credit limit, and may treat the credit line as revolving credit, by borrowing and paying back, and borrowing again.

Interest rates applied to HELOC’s are variable so it is important to calculate the worst case scenario of repayments. It is also advisable to seek out a HELOC with a capped interest rate. There will be fees payable to arrange a HELOC, and it pays for borrowers to ensure that repayments are allocated to both the principal and the interest.

HELOC’s have the advantage over loans in that the amount borrowed can be staggered, with interest only charged on the amount of credit used, whereas loans are charged interest on the full amount. Neither is recommended for frivolous purposes, as borrowing against equity is risky, and it is more fiscally sound to build up home equity than to reduce it.

If a borrower elects for either a home equity loan or a HELOC they should be aware that both would need repaying in full if the property was sold. The risk involved with both types of home equity credit is that the equity in the home is reduced. If house prices fall, borrowers can easily become mired in negative equity, making them at higher risk of foreclosure.

Source: money cnn