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Written by admin on September 25th, 2008

Home Equity Loans And The Debt They Cause

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What is home equity? When you take out a mortgage to buy a home, your home equity is the amount of your mortgage that you’ve already paid off. Your home equity is the “proportion” of your home that you own–up to the entire value of the home. If the market value of your home has increased, refinancing your mortgage will increase your home equity.

Your home equity is a valuable security against which to finance additional loans. However, to get the best rates on home equity loans, you need to know how the system works. What types of home equity loans exist out there? How are their interest rates determined?

First, keep in mind that there’s a difference between home equity loans and home equity lines of credit (abbreviated, rather cumbersomely, as HELOCs). With home equity loans, you receive a set amount of money as soon as you take out the loan. That money must be repaid at a set interest rate. To pay off your home equity loan, you’ll be sending out the same amount of money every month.

HELOCs work more like credit cards. Like a credit card, a HELOC lets you take out as much money as you need (up to a set limit), whenever you need. Also like credit cards, HELOCs don’t predetermine the payments you have to make to pay off what you owe. Instead of always paying some proportion of the principal, plus the monthly interest, on a HELOC, you can make “minimum payments” consisting of only the monthly interest.

Either way, you’ll be borrowing money against the home equity that you own.

An additional, and very important difference between home equity loans and home equity lines of credit lies in how your lender calculates the interest rate for each.

The interest rate on home equity loans depends the same kinds of long-term factors that influence interest rates on fixed-rate home mortgages–for example, the 10-year US Treasury note. Thus, the interest rates on home equity loans are independent on the actions of the Federal Reserve Board, which only has the power to affect the US prime rate. The interest rates on HELOCs–like the interest rates on credit cards–are determined by the US prime rate. Thus, these rates are directly influenced by the actions of the Fed.

These days, home equity lines of credit are in some ways to your advantage, if you seek to borrow money against your home equity. That is because the Fed has dramatically reduced the US prime rate over the course of the past year.

On the other hand, the housing crisis has many financial institutions worried when it comes to home equity anything. It’s hard to rely on home equity to secure a big loan, with the value of homes as uncertain as it is today. Consequently, many financial institutions are reducing the amount of home equity lines of credit that they offer. They’re also making it more and more difficult to qualify for home equity loans, especially at the low interest rates people want.

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