Home equity loans can be great financial tools that not only facilitate home improvements but also contribute toward building wealth. Proper use is essential, however. Just as a knife is helpful when cutting open a box, it can also hurt you if it's used carelessly.

Through a combination of proper planning, an evaluation of current markets, and the guidance of a mortgage professional, you should be able to determine the best use of the options available to you.

Why Obtain a Home Equity Loan?

There are a number of very good reasons to take out a home equity loan. A few examples are: home improvement; debt consolidation to reduce overall interest costs; and the creation of an available fund, so that you won't have to deplete other financial assets in the event you're faced with an emergency.

Home equity loans can also be utilized to eliminate Private Mortgage Insurance, or PMI, when putting less than 20% down on a home purchase. In this case, the second mortgage is often referred to as a "piggyback" loan. This type of loan can allow a home buyer to put as little as no money down and still avoid paying PMI.

Just as there are good reasons to utilize a home equity loan, there are also some poor reasons. The most important of these is consumption. Home equity loans are not a good vehicle to fund your lifestyle choices. For example, you may not want to write a check from your home equity account to buy a jet ski.

What About Rates?

The interest rates you will pay for a home equity loan vary and typically carry higher rates than those paid on a first mortgage. Interest rates can vary dramatically depending on the amount being borrowed, the amount of equity remaining in your home after the loan is taken out, and the credit score of the borrower(s). Rates can also vary by property type: single family residence, condominium, or multiple units (duplex, tri-plex or quad-plex); and occupancy: owner-occupied versus investment property.

Rates can run anywhere from approximately 1.00% to nearly 7.00% higher as compared to a first mortgage. Lower rates are associated with higher loan amounts, higher credit scores and more equity remaining available, or combined loan(s) to the appraised value of your home, after the loan is closed.

Two Options for Tapping Into Home Equity

A key point to remember is that there are two options available to you when considering a second mortgage against your home. One is known as a Home Equity Line of Credit or HELOC. The other is known as a Home Equity Loan. While both provide you access to the available equity in your home, the way each is structured is entirely different.

Home Equity Line of Credit

Let's look at HELOCs first. HELOCs offer tremendous flexibility in that the loan is an open line of credit which you may access at your convenience, up to the available limit. There's also no predetermined monthly payment. HELOCs may be obtained with little to no closing costs.

HELOCs provide for interest only payments in the early term of the loan, offering the borrower the luxury of borrowing more while paying less than would be required of a Home Equity Loan. In general though, the interest only period will not extend beyond ten years; at which time the loan will be amortized over the remaining term of the loan, typically another five or ten years.

In the case of a HELOC, the interest rate will be adjustable, with movements in the interest rate tied to the Prime Rate either offered by your bank or as quoted in the Wall Street Journal. Attached to the Prime Rate will be a margin, and the two numbers added together will equal the rate of interest you will owe. The margin will be determined by the factors mentioned previously.

In the case of a rising interest rate environment, it is especially important to consider all factors to determine whether this is the best option available.

Home Equity Loan

Home Equity Loans are similar to a traditional fixed rate first mortgage. Money is borrowed for a specified term, and regular monthly payments are required for the term of the loan.

The term of a Home Equity Loan can vary by institution, and it can be for as short as five years or as long as twenty years. In some cases, a lender may offer a fifteen year loan with payments amortized over a thirty year period, with a balloon payment due at the end of the loan.

The interest rates offered for Home Equity Loans are generally fixed for the term of the loan and vary according the factors mentioned previously.

Time for Evaluation

Home equity loans are tremendous vehicles for helping people achieve home ownership and offering ways to help property owners maximize their tax deductions. This is the case because the interest is normally tax deductible for these loans, as compared to consumer loans.

If you currently have a HELOC, however, you may want to consider what the combined rate of interest is that you're currently paying for both your first and second mortgage. It may make sense to refinance the two into a new first mortgage that can offer not only a lower payment than the two you are paying currently, but also a lower effective rate of interest.

When considering any of these options, the best way to begin is by talking to your mortgage professional and tax advisor. If you have any questions regarding how a home equity loan can benefit you, call me today!