Types Home Equity Loans
are two basic types of home equity loans: the standard home equity
loan and a home equity line of credit. Another way of borrowing
against home equity is cash-out refinancing.
The Standard Home Equity Loan
A standard home equity loan, (also called a term loan, a closed-end
loan or a second mortgage installment loan), works like a traditional
loan. You receive a lump sum payment at a fixed interest rate and
you pay the money back in monthly payments over the life of the
loan. Since the interest rate on the loan is fixed, your monthly
payments will also be fixed.
An example of this is a home equity loan for $30,000 with an interest
rate of 7.5% where you pay the money back in monthly payments of
$356.11 over the 10 year life of the loan.
Home Equity Line of Credit
A home equity line of credit works like any other line of credit.
You are granted an amount you can borrow and you draw money from
the account as you need it. You pay interest on only the amount
actually borrowed and the interest rate is variable over the life
of the loan. While most home equity lines of credit have a variable
interest rate, a fixed interest rate can sometimes be negotiated.
A home equity line of credit is 'revolving' meaning that you can
borrow money, pay off the borrowed money and then re-borrow that
money. The money in a home equity line of credit is accessed using
specially issued checks or credit cards
Here is an example of a home equity line of credit: You are given
a $20,000 home equity line of credit. You borrow $10,000 dollars
and are charged a 5% interest rate. The interest rate for the home
equity line of credit is not fixed but varies with changes in interest
rates. If you pay back $5,000 towards the principal, you still have
$15,000 in your line of credit that you can borrow against as needed.
While cash out refinancing is not a type of home equity loan, it
does allow you to borrow against the equity in your home. In cash
out refinancing you take out a new mortgage that is greater than
what you owe on your current mortgage - you pay off your current
mortgage and use the difference as a home equity loan.
Here is an example of cash out refinancing. Your home is valued
at $150,000. Your mortgage is $100,000 and you have $50,000 worth
of equity in your home. When you bought your home, you got the going
mortgage rate which was 9%. Interest rates have since come down
and you decide to take advantage of the lower rates and also borrow
$20,000 from your equity for a home improvement project. You take
out a new loan for the $120,000 at 6% - you use $100, 000 of that
to pay your old mortgage and $20,000 for your home improvement project.
You now have a $120,000 mortgage at 6% where as you previously had
a $100,000 mortgage at 9%. The difference of $20,000 is the way
in which cash out refinancing replaces a home equity loan.
Cash out refinancing typically has a lower interest rate than a
home equity loan but closing costs associated with cash out refinancing
are higher than closing costs associated with a home equity loan.