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Basic information on home equity loans and lines of credit

Are you confused about what a home equity loan and line of credit are? Read on and you will find the difference between the two and perhaps other useful data.

First thing you should know is what home equity is. Equity is the difference between how much the home is worth and how much you owe on the home. What you owe is the amount left to pay off the mortgage or mortgages as the case may be.

Here is some math on that. You purchased your home for $300,000. At the time of purchase you paid $50,000 as the down payment. This left a balance of $250,000 (your mortgage). The equity amount at this time is the down payment amount ($50,000).

Now let us say 5 years have passed and you have made your monthly mortgage payments which has paid down$50,000 of your mortgage. Thus you have $200,000 you owe on this house ($250,000 minus $50,000 equals $200,000). Also in this 5 years the value of the home has appreciated and is now worth $400,000. To figure out what your equity is you take the current value of the home ($400,000) and minus what you owe ($200,000) and you end up with your equity ($200,000).

This equity can now be borrowed. The most common ways are a home equity loan or line of credit. Both of these use the house as collateral.

Collateral is property that you pledge as a guarantee that you will repay a debt. If you don’t repay, the lender can take your collateral (in this case, your house) and sell it to get the money back. Not paying back the debt can mean the loss of your house as that is what you have put down as collateral. The lender then will demand that you move and relinquish the property.

These two types of home equity debt, home equity loans and home equity lines of credit, are also known as HELOCs. Both can also be referred to as a second mortgage since they are secured by your house, just like the original, or first mortgage.

Let’s start with the home equity loan. This is a one-time lump sum you receive based off of the equity you have in your home. This loan has a fixed interest rate, a fixed monthly payment and is paid back over a set amount of time. This is a one time loan and you cannot borrow further on this loan as it is fixed.

The HELCO or home equity line of credit, works along the lines of a credit card. A HELOC allows you to borrow up to a certain amount, the line of credit for the life of the loan. A time limit will be set by the lender. While this line of credit is active you may withdraw money as you need it, up to the agreed upon limit. As stated, like a credit card, since you can continue to borrow and make payments keeping within the amount agreed as the line of credit.

Here is an example, just in case you became confused on the line of credit:

Let’s say you have a $10,000 line of credit. You borrow $8,000 to pay for remodeling your bathroom. You now now owe the $8,000 you borrowed. Since the line of credit is $10,000 you have $2,000 which you can still borrow.

As time goes on you make your payments and you do not borrow any further funds, you are paying off this debt and increasing the amount of money available to you.

Now for the pros and cons of each. A HELOC gives you more flexibility than a fixed-rate home equity loan. The home equity loan can also keep you in debt longer as you pay down interest before principal.

A line of credit has a variable interest rate that fluctuates over the life of the loan. Payments vary depending on the interest rate and the amount owed.

More terms and what they mean. A HELCO has a draw period which means you can borrow against the line of credit and make minimum monthly payments. This minimum usually covers interest only. You still have the option to pay principal.

During the repayment period, you can not add new debt and must repay the balance over the remaining life of the loan.

The draw period often is five to ten years and the repayment period ten to 15 years. Each lender can set these time limits.

A line of credit can be accessed by check, credit card or electronic transfer ordered by phone. Lenders often require you to take an initial amount when you set up the loan. There may be a minimum amount set each time you want to use these funds. Some require that you keep a minimum amount outstanding.

A home equity loan is usually repaid within 15 years but can vary depending on the lender.

One common factor with each of these methods of using the equity in your home is that they must be paid off in full when you sell the house.

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