What is a home equity loan?  As defined in the dictionary, equity is the value of a homeowner's unencumbered interest in real estate. Equity is computed by subtracting from the property's fair market value the total of the unpaid mortgage balance and any outstanding liens or other debts against the property. A homeowner's equity increases as the mortgage is paid off or as the property appreciates in value. When the mortgage and all other debts against the property are paid in full the homeowner has 100% equity in the property.

By using the equity in your home, you may qualify for a sizable amount of credit, available for use when and how you please, at an interest rate that is relatively low compared to many types of debt, such as credit card interest rates.  You can use a home equity loan to save money and get out of debt faster; make home improvements or buy a new car; fund your children's education, a dream vacation or other major expenditure; or finance your day-to-day business expenses.  Furthermore, under the tax law-depending on your specific situation-you may be allowed to deduct the interest because the debt is secured by your home.   Whether or not you will be able to take tax deductions depends on your personal situation.  Do not assume you will be able to deduct the interest; ask a tax professional or accountant for clarification.

Those who obtain a home equity loan are granted a specific amount of credit, which is the maximum amount that can be borrowed.  Many lenders set the credit limit on a home equity line by taking a percentage (say, 75 percent) of the appraised value of the home and subtracting the balance owed on the existing mortgage.  For example:

Appraisal of home                      $100,000
Percentage                                     x 75%
Percentage of appraised value      $ 75,000
Less mortgage debt                     - 40,000
Potential credit line                       $35,000

Other lenders may let you borrow 100 percent of the appraised value of your property.  It depends on the lender and the area of the country in which you live.  In determining your actual credit line, the lender also will consider your ability to repay, by looking at your income, debts, and other financial obligations, as well as your credit score.

Home equity plans often set a fixed time during which you can borrow money, such as 10 years.  When this period is up, the plan may allow you to renew the credit line.  But in a plan that does not allow renewals, you will not be able to borrow additional money once the time has expired.  Some plans may call for payment in full of any outstanding balance. Others may permit you to repay over a fixed time, for example 10 years.

Once approved for the home equity plan, usually you will be able to borrow up to your credit limit whenever you want. Typically, you will be able to draw on your line by using special checks the lender will give to you.

Under some plans, borrowers can use a credit card or other means to borrow money and make purchases using the line. However, there may be limitations on how you use the line.  Some plans may require you to borrow a minimum amount each time you draw on the line (for example, $300) and to keep a minimum amount outstanding.  Some lenders also may require that you take an initial advance when you first set up the line of credit.

For these reasons, it is very important that you read any agreement in full before signing on the dotted line.  Make sure you understand all of the terms of the loan and expenses associated with it, as well as your obligations and rights.

cont'd on next page -- A home equity line of credit vs. a second mortgage >>
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