Like HowStuffWorks on Facebook!

How Home Equity Loans Work

Home Equity Loans and Reverse Mortgages
A home equity line of credit can help you pay for your kids' college tuitions.
A home equity line of credit can help you pay for your kids' college tuitions.
Photo courtesy stock.xchng

A home equity loan is most useful when you need a specific amount of money for a project or investment. As we’ve established, a home equity loan involves borrowing against the equity in your house. The loan comes in a fixed amount that is repayable over a set period of time, which is why this type of loan is commonly referred to as a second mortgage. The payment schedule is usually designed around equal payments that will eventually pay off the entire loan.

Like with other types of equity plans, the interest on a home equity loan may be tax deductible up to $100,000.

As with a home equity loan, the borrower’s home serves as the collateral in a Home Equity Credit Line (HELOC). In a basic sense, a HELOC works like a kind of credit card. The lender examines various factors like the borrower’s income, credit history, expenses and other debts and sets the credit limit at a percentage of the home’s equity.

There is a fixed time frame applied to a HELOC, but it works slightly differently than with a home equity loan. The first time frame -- say, five years -- is the period during which the borrower can draw money using special checks, electronic transfers or even a special credit card. Different plans have different rules, but in some cases a minimum amount has to be withdrawn each time. Like a credit card, the borrower has a limit on how much money is at his or her disposal. If the borrower reaches the pre-established limit, he or she cannot borrow any more money without paying off some of the outstanding debt.

The second time frame comes at the end of the borrowing period. Some plans have an option for renewing the credit line while others require a repayment of the debt -- usually over another fixed time period. In other cases, the outstanding debt can be “rolled” into a traditional loan at the end of the drawing period.

Because the terms of home equity credit lines vary, it’s important to find one that fits your specific needs. When choosing one of these plans, consider the annual percentage rate (APR) and other costs of the plan. Like many other types of loans, a home equity plan can come with many fees attached, though some lenders may dispense with some, or even all, of the charges. In any case, these charges often include an application fee, property appraisal, initial charges such as points (which go against your credit limit), attorney’s fees, title search, mortgage preparation and filing fees, property and title insurance, taxes, membership or maintenance fees and even transaction fees when drawing on the line of credit.

The structure of the drawing and repayment periods should be considered carefully. Is the repayment period too short? Will you be able to make payments against the interest during your drawing period? These are only some of the questions to ask when considering a home equity line of credit. Also, if you are concerned that the ability to draw on a line of credit almost at will offers too much flexibility or will tempt you to spend excessively, then this is probably not the type of loan for you. But if you need money in installments -- perhaps for paying a contractor for more than one project or paying tuition, a home equity line of credit can be a very good choice.

Reverse Mortgages

A reverse mortgage can seem like a contradiction in terms. It’s money that the bank pays you that you might not have to repay for the rest of your life. You don’t even have to have an income to be eligible.

There are, of course, conditions attached to a reverse mortgage. First, you have to be at least 62 years of age and live in the home applying for the reverse mortgage for at least 50 percent of the year. You also have to own your home. In some cases, if you have a relatively small amount remaining on your home mortgage, you can get a cash advance from the reverse mortgage to pay off the rest of the debt on your house.

But the idea of a loan that you never have to repay can be misleading. If you sell your reverse mortgaged home or permanently move out, you have to repay the loan. If you do stay in the home and maintain the reverse mortgage until you pass away, the mortgage is designed to be paid off with the value of the home. But if your heirs wish to keep the house, they will have to pay off the loan. Otherwise, it will likely become property of the lender, or if the home is worth more than the loan balance, your heirs may sell the home, repay the loan and retain the difference.

Unlike a traditional or “forward” mortgage, a reverse mortgage involves rising debt and falling equity. Your debt increases as your equity decreases.

A reverse mortgage could help you buy that boat you've been eyeing since you retired, but it's important to know that eventually someone will have to repay the loan.
A reverse mortgage could help you buy that boat you've been eyeing since you retired, but it's important to know that eventually someone will have to repay the loan.
Photo courtesy stock.xchng

Among the different types of reverse mortgages, a Home Equity Conversion Mortgage (HECM) is the only reverse mortgage that’s federally insured. The HECM program limits loan costs and tells the lender how much they can lend you. This mortgage can be cheaper than other reverse mortgages. Usually only reverse mortgages offered by state and local governments are cheaper than an HECM, but those often must be used for a particular purpose and are mostly available to those in lower income brackets. If you’re interested in how much you can receive through an HECM or a Home Keeper Mortgage from Fannie Mae, try this mortgage calculator.