Convenience and tax-deductible interest make tapping the equity in your home rather appealing. Just be careful that you don't take a casual view about draining the equity in your home—it could jeopardize your most important asset.
CAUTION: If you fail to make the loan payments, you could ultimately lose your home in a foreclosure.
There are generally two types of such loans: home equity loans and home equity lines of credit.
Home equity loans, sometimes referred to as second mortgages, involve borrowing money and making principal and interest periods over a specified period of time. Here are some features of home equity loans:
- Your repayment period can vary. However, lenders will generally not allow a repayment period of more than 20 years.
- Typically, you may be able to borrow up to 80% (this may be higher depending on the lender and your credit rating) of the current appraised value of your home, minus your outstanding mortgage balance.
- Interest rates are generally higher than on first mortgage loans.
- Lenders usually offer a choice between a fixed-rate and adjustable-rate loans.
Another way to tap the equity in your home is with a home equity line of credit. Instead of borrowing a fixed amount of money at one time, you can establish a line of credit against the equity in your home and draw on the money as you need it. The lender will set a limit on the total amount you can borrow and will issue you checks. It is almost like a checking account, except you have to pay back the money and you must pay interest on the balance due. Following are some features of a home equity credit line.
- The maximum credit line is typically limited up to 90% (depending on your credit rating) of the current appraised value of your home, minus your outstanding mortgage balance.
- Interest is usually a variable or adjustable rate that can vary as often as monthly.
CAUTION: If you get a variable rate loan, be prepared for the fact that rates may rise—can you handle the resulting increase in monthly payments?
Rule of thumb: Your mortgage payments, property taxes, and homeowner's insurance should not be more than 28% of your gross income; and those costs plus any other debts you have should not be more than 36% of your gross income.
- You only pay interest on what you borrow, not on the entire line of credit.
- Lenders typically require a minimum monthly payment on any outstanding loan amount.
- Most home equity lines are divided into two periods; a draw period and a payback period. A draw period—the period of time you are able to draw from the credit line—can last up to twenty years. The payback period is the period of time you have to pay back the outstanding balance. It usually ranges from ten to twenty years.
With this type of loan you only borrow when you need the money and you are not required to fill out additional loan applications—just the initial one.