Pros And Cons

For homeowners with poor or bad credit, a home equity loan or home equity line of credit can be a viable resource to securing funds for a number of projects, such as improvements to your home, starting a business, paying for college tuition or paying for emergency medical procedures.

But like any major financial transaction, applying for a home equity loan or home equity line of credit has its pros and cons. And if you’re already struggling with credit problems, adding home equity loan or home equity line of credit payments can only increase the problems if you fail to prepare for the process.

Before applying for a home equity loan or home equity line of credit, get familiar with the pros and cons of applying for the loans before signing on the dotted line. Knowing the advantages and possible pitfalls can get you prepared for successfully negotiating the home loan process.

In brief, a home equity loan (also known as a second mortgage) is a set amount of money loaned to you that is based on the value of your home. The loan must be repaid by a set amount of time (usually 10 to 30 years) and the borrower must make regularly scheduled monthly repayments that include the principal and the interest. Interest rates are based on the Prime Rate and can either be variable (a rate that moves up or down based on changes in the interest rate index) or fixed.

A home equity line of credit, like a home equity loan, is an amount loaned to you based on the value of your home. But unlike a home equity loan, a home equity line of credit operates like a credit card. The borrower can take money out of the account at any time during a period of typically five and 20 years. Withdrawals can take the form of a credit card or a check linked to the account. Once the access period has ended, you must begin payments (a combination of the principal and the interest). Typically, the borrower has between 10 and 20 years to replay the loan or they may be scheduled for a balloon payment, which is payment of the entire principal in one lump sum.

The advantages of a home equity loan are its low interest rates, which tend to be lower that the rates for credit cards or other types of loans. Home equity loans are also tax deductible; the interest on the loan is deductible up to $100,000 or the equity of your home, whichever amount is less.  And a home equity loan is often flexible, meaning you make the decision on when to use the money and you can often set the date when you will begin repaying the principal.

The disadvantages of a home equity loan are the risk of losing your home should you default on the loan. Being late with a payment or missing a payment could result in the lender beginning the foreclosure process. Second, with a variable interest rate loan, your monthly payments could rise higher than you anticipated, though most loans have a cap on the interest rate that limits how much it can rise in a year and over the entire length of the loan term. Finally, lenders can impose any number of fees for the application process, origination and withdrawals.

With a home equity line of credit, the advantages are the freedom to withdraw money from the line of credit as often as you wish, up to the full amount of the loan and for the length of the withdrawal period. And you only pay interest on the money you withdraw. In addition, a portion or the entire interest on the line of credit may be tax deductible. Finally, the home equity line of credit will most likely have a variable rate of interest, meaning the interest rate could go up or down depending on the current market rate. The interest rate for a home equity line of credit is usually lower than the rate for most other types of credit.

The disadvantages of a home equity line of credit include a mandatory minimum or maximum amount you must withdraw each time you access your line of credit. If you sell your home, you will have to pay off the full credit line. And after a pre-established period, you will have to either pay the line of credit off in full, renegotiate your line of credit or create a new repayment schedule.

It’s important to understand all of the terms of a home equity loan or home equity line of credit. Know the terms of repayment, how the interest rate is calculated and the possible penalties for late or missed payments. Having this information can help you avoid the downside of a home equity loan or home equity line of credit.