What is a Home Equity Loan?
A Home Equity Loan (HEL) is a loan secured by the portion of your home's value you own outright. That's defined as the difference between your home's appraised value and your current mortgage balance. Because homes generally hold or grow in value over time, HEL rates tend to be very low. They're always lower than credit cards and most consumer loans.
Generally, HELs come in three types – lines of credit, fixed-rate installment, and combinations of the two.
- Home Equity Lines of Credit – Sometimes called HELOCs, these loans give you a credit limit you can borrow against. As you pay back your loan advances, those amounts again becomes available to borrow. HELOCs typically have a draw period (the number of years during which you can take loan advances) and a repayment period (the maximum number of years you can take to repay any balance remaining at the end of the draw period). The ability to get advances whenever you need them is the big advantage of HELOCs. For example, if you are building an addition to your home, you can write a HELOC check for each expense as it comes up. You only begin to pay interest on each amount as the check clears your account.
HELOCs have variable rates that follow a published index. The Prime Rate is most often used. The Prime is the rate a bank charges its best business customers for commercial loans. The actual rate you pay will be expressed as a percentage above or below the index. For example, if the loan rate is Prime + 1% and Prime is 7%, your fully indexed rate will be 8%. As the index moves up or down, so can your rate – typically once a month.
You can make advances on most lines of credit by simply writing a check. DCU also allows you to make advances by transfer to another DCU account using PC Branch, Easy Touch, DCU ATMs, or at the teller counter.
- Fixed-Rate Home Equity Loan – Also known as a Home Equity Loan or Home Equity Installment Loan, this loan gives you a one-time loan advance. The monthly payment and interest rate remain the same for the life of your loan much like an auto loan. People generally use Fixed-Rate HELs for a single major expense such as an auto purchase.
- Combination Loans – These loans are the most convenient but are the most challenging to understand. In a combination loan, the primary account is a HELOC that works as other HELOCs do. The combination feature lets you take a portion of your line of credit and set it up as a fixed-rate advance. As the principal on the fixed-rate portion is paid down, it becomes available to borrow again on the line of credit portion.
Why is this advantageous? Say you decided to buy a car with your home equity, but wanted to pay it off in five years. You can get a fixed-rate advance for the car and pay it off in equal payments for the five years. If you paid it with the line portion, your monthly payment would vary with changes in rates and changes in your balance, making budgeting the payments more difficult. However, if you just got a fixed-rate HEL, you'd have to open another loan the next time you wanted to finance something. What's more, depending on how the institution sets rates on these loans, the line portion or the loan portion could have a better rate when you are ready for an advance. You can choose the option that saves you the most without having to open a new loan.
Most people use HELs for home improvement, bill consolidation, auto purchases, or education.
The Tax Advantages of Home Equity Loans
HELs are the only type of loan where you can borrow for any purpose and, for most people, the interest is tax deductible. The tax advantages can make these loans even more affordable if you itemize deductions. See you tax advisor to determine how these tax advantages apply to you.
Between the tax savings and lower interest, you can greatly reduce your cost of financing
the products and services you buy.
Source: DCU StreetWise - ((http://www.dcu.org/prodserv/loans/hel_why-index.html))
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