Home Equity Loans: Pros and Cons

Home equity loans are borrowed to serve many purposes. Businessmen use the money borrowed to expand their business. Many a times, parents take home equity loans to pay their childrens' fees. This type of loan is useful especially for higher studies in a foreign country. Also, such loans are available at low interest rates compared to those of credit cards.

What is home equity?
The term 'Home equity' is calculated by deducting the outstanding balance of liens from the actual market value of the home. The actual market value of a property can be calculated by detailed research of the real estate market. Home equity loans are also referred to as "second mortgage loans". However, there is a difference between home equity loans and home equity line of credit (HELOC). HELOC does not have a fixed credit limit and the interest rates are variable. On the other hand, home equity loan has a credit limit and is a lump sum amount with fixed rate of interest.

There are many things which banks/financial institutions consider before sanctioning a home equity loan. The credit history of the loan applicant is studied carefully. The loan application may get rejected if it is found that the applicant has not cleared his previous dues. Individuals with good credit history get preference while sanctioning loans. Credit history can decide whether the applicant is credit worthy or not.

Types and pros of home equity loans
Banks prefer to forward loans by taking property as collateral. The reason for this is that if the borrower defaults on the payments, the bank can recover its money by auctioning off the property. The process of applying for these loans is simple and inexpensive. These loans serve the vital purposes of debt consolidation, medical treatment costs and emergencies. The most striking advantage of home equity loans is that we can get a rebate in income tax provided we produce all required documents. Along with sanctioning loan, the lender provides homeowners insurance policy to the borrower.

There are two types of home equity loans. They are - closed end home equity loans and open end home equity loans. In closed end HEL's, the loan applicant receives the entire amount at the time of closing. He cannot borrow any money further. Closing is the last step in the execution of a real estate transaction. In some cases, banks sanction loan upto 100% of the value of the home. The main point considered is the income of the applicant. Stability of income assures the bank that it will get its equated monthly installments (EMI's) on time. Closed end HEL's have fixed interest rates and have repayment period of 15 years.

In the case of open end HEL's, the borrower is free to choose when and how often to borrow against the equity. Like closed end HEL's we can get loan equal to 100% of value of home. This loan has a repayment period of 30 years with variable interest rates. The EMI's can be as low as only the due interest.

Cons of home equity loans
However, we should also consider the other side of the coin. There are certain cons of home equity loans. The biggest loss to the borrower can be the permanent loss of ownership of his property if he defaults in the payment of the EMI's. As the duration of the loan is high, the homeowner may face serious problems if the market value of his home goes on declining. Sharp decrease in home prices is common during the phase of recession. To avoid this, borrowers should think about their ability to repay. One should apply for a home loan only when he is financially well settled. Elderly people should be well aware of the complications involved in repayment as they are nearing retirement. Floating interest rates increase the EMI's by large amounts and disturb our monthly budget as the monthly income is fixed. A businessman should have faith in himself that he will earn a decent profit on his investments.

A home is a place where a person can find peace and solace after working hard throughout the day. Loss of this precious thing may lead to severe depression and frustration in some people. So it is better to look (into the pros and cons of home equity loans) before you leap.