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What to know about home equity loans and lines of credit

January 4, 2017
Second mortgages are attractive due to their low interest rates and ease of availability for homeowners, but like any other type of loan, they come with their own unique risks.

If you're a homeowner, you are probably working to pay off a mortgage along with other typical expenses. These obligations can make saving for other, less urgent needs more difficult. You may have heard of alternative mortgage options which provide extra funding for your household. Second mortgages are attractive due to their low interest rates and ease of availability for homeowners, but like any other type of loan, they come with their own unique risks. If you're thinking of opening a second mortgage, here are some basic facts to know.

Understanding Home Equity

Second mortgages and reverse mortgages allow you to borrow money with your home equity being used as collateral. Since home equity is not liquid cash, it's meaning and value can be a bit confusing. As Bankrate explained in an article on the subject, home equity is the difference between the value of your home and the amount you still owe on your mortgage. This is why a second mortgage is a general term for two specific types of home equity lending products.

Loans and Lines of Credit

The most basic type of second mortgage is a home equity loan. With this type of loan, you are able to borrow a one-time lump sum of cash based on your home's existing equity. You then pay down this amount over time, usually over at least 15 years according to U.S. News & World Report. During this time, the interest rate usually does not change. The other type of second mortgage is known as a home equity line of credit (HELOC). This product functions more similarly to a credit card since it allows you to carry a revolving balance.

"A second mortgage generally describes two different home equity credit products.”

As Bankrate explained, HELOCs are broken up into two periods. In the first, you withdraw an amount being loaned to you. You must pay back the principal of the loan in the second period. During the withdrawal period, you can use as much of your available credit as you need and only pay the interest on the debt. This is typically the first five to 10 years. During the repayment period, you are not able to take on any more debt and must begin paying the principal plus interest. This period is usually 10 to 15 years long. Interest rates may be subject to change for HELOCs.

The Main Draw

Why bother taking out a loan based on your home equity? There are many reasons people do so, and some of them more responsible than others. Since the risk of a second mortgage is covered by your home's equity, some may find it easier to get approved. The interest rates associated with second mortgages tend to be lower than other types of loans. According to Bankrate's compiling of average home equity loan rates, as well as rates from specific lenders, borrowers with good credit can expect rates between 3 and 8 percent. These lower rates make them attractive options for those looking to finance college tuition, high medical bills, major home renovations and other high cost, long-term expenses. Some homeowners may use a second mortgage to pay off higher-interest debt. In truth, these funds can be used to pay for just about anything, including seed money for a new business venture.

The Drawbacks

By now, you're probably wondering about the downsides to home equity financing. There are certainly many, although they are not much different than the risks inherent in taking on any other type of debt. Since second mortgages are secured by the value of your house, not paying them back means risking perhaps the most essential thing you own. The other primary risk concerns the value of that in which you invest the borrowed funds. If you use a HELOC to fund a new business, for example, there is no guarantee you will succeed enough to repay the principal with interest.

"Home equity interest rates often change with the market.”

While you may be able to secure a lower interest rate on a home equity loan compared to a student loan for college funds, home equity rates often change based on the market, according to U.S. News & World Report. This means that the amount that a second mortgage will actually cost you can vary and unexpectedly high payments can make financial planning difficult. The Federal Deposit Insurance Corporation wrote a comprehensive guide to selecting a second mortgage and your associated rights and encourages homeowners to shop around and consider all options.

Ultimately, a second mortgage can be a good tool to actually increase your home's value over time. Using the loan to renovate your home will increase its value and can end up paying off when it's time to sell. Responsible use of a second mortgage is just like responsible use of any other type of debt. Always know the risks and understand how to minimize those dangers. You may be surprised how much you could benefit.