Five Things You Should Know About Home Equity Loans

Home equity is an active part of the financial strategies of American households. That is, rather than something to be built up passively over time, it has become an asset that people actively tap into for a variety of purposes. This can make a lot of sense, but before you take advantage of this hard-earned asset, there are five things you should know about home equity loans.

Better Choices Through Understanding

Essentially, using a home equity loan represents some choice--to use an asset to finance a new purchase, and to use a second mortgage to access that asset as opposed to other methods of financing. To help you make the right choices, here are five things you should know about home equity loans:

1. Home equity loans carry the same obligations as your primary mortgage. Home equity loans are known as "second mortgages," but to the borrower, they essentially mean the same thing as a primary mortgage. Specifically, both primary and secondary mortgages are loans made against the value of a property, with the property subject to foreclosure if the loan obligations are not met. So, this is serious business--a $10,000 home equity loan can put your $300,000 home in play if you do not meet your obligation to make principal and interest payments on schedule.


2. Home equity loans have higher interest rates than primary mortgages. While a second mortgage may carry the same obligations as a primary mortgage to the borrower, there is one important difference. In the event of a foreclosure, the holder of the primary mortgage would have first claim against the asset, leaving the holder of the second mortgage to settle for whatever value is left over. Because of this greater risk, second mortgage lenders typically charge higher interest rates. This means that under some circumstances it may make more sense to refinance into a new primary mortgage with some added principal, rather than pay a higher rate on a home equity loan.


3. Home equity loans may effectively lengthen your mortgage. If you are close to paying off your primary mortgage, a home equity loan could effectively lengthen the time over which your home is mortgaged. This is another reason to consider whether it makes sense to refinance instead. Lengthening a primary mortgage at a lower interest rate may be a cheaper alternative to tacking on years with a home equity loan.


4. Having equity does not mean having the ability to pay. You may qualify for a second mortgage based on the amount of equity in your home, but this does not guarantee that there is room in your household budget to make the payments. Always budget before you borrow--find out what level of payments you are looking at, and see what this will do to your monthly budget.


5. There may be cheaper alternatives. As described above, there may be times when it makes more sense to refinance than to get a home equity loan. Another alternative is a home equity line of credit--credit you can tap into as needed, and only pay interest on when you are using the money. This may be more practical than a single home equity loan if you are planning on a series of projects over time.

About the Author:
Richard Barrington has been a businessman and writer for a quarter century. Shortly after graduating Magna Cum Laude from St. John Fisher College in 1983, Richard joined Manning & Napier Advisors, Inc., a Registered Investment Advisor. Starting in an entry-level operations position, he worked his way up to become head of marketing and client service, an owner of the firm, and a member of its governing Executive Committee. His efforts contributed to the firms growth from slightly over $1 billion in assets under management when he joined, to over $12 billion in 2006. While at Manning & Napier, Richard earned the Chartered Financial Analyst (CFA) designation from the Association of Investment Management and Research (now the CFA Institute").

In August, 2006, Richard retired from the investment business to pursue a writing career. He has worked primarily as a freelance writer on a variety of business topics, while also writing manuscripts for three books.