When a borrower receives a lump-sum amount from a home equity loan, it is referred to as a closed end home equity loan. That is contrasted with a home equity line of credit where he is granted the right to draw down an amount up to the total value of his line of credit. A closed end home equity loan is often written for 15 years, can have a fixed rate of interest, and it requires that the borrower make monthly payments until the loan is paid. These loans are considered traditional second mortgages.
If you own your home and you have built up enough equity, a closed end home equity loan can provide you with the cash you need while providing you with a number of benefits. First, the interest rate you will pay is considerably lower that interest charged on either your credit cards or a personal loan. Moreover, in most cases, the interest you pay can be tax-deductible, although you should check further with your tax advisor. Finally, you can choose when to use the money because the proceeds of your loan can be placed in a saving account to earn interest. And under most cases, you can decide when the loan will be paid in its entirety.
Before making a closed end home equity loan, you should understand some of its disadvantages. First, you will risk the loss of your home if you cannot either refinance the loan or have difficulty in repaying it. A closed end home equity loan is secured by your home as collateral. And, if you are 60 to 90 days late in making payments, your lender may be forced to foreclose on your house. Further, if you have chosen a loan with a variable rate, you should be aware that your monthly payments will rise when interest rates rise. Finally, the closing cost of your loan can be substantial, so it will be smart for you to know what they will be before you embark on a loan of this type.
The amount of the closed end home equity loan is a function of both the value of your home and a lender's policies. For example, many banks will lend you up to 85 percent of your home's appraised value, less the amount of other loans secured by your home. Of course, that is after being satisfied with your credit history and your ability to pay the loan back.
There have been instances where home equity has risen dramatically and lured homeowners to take advantage of them by borrowing against their homes. In some cases, they have done so more than once by either refinancing their homes or by borrowing additional amounts through closed end home equity loans with successive liens on their homes. Then home values rapidly declined and many of those borrowers owed more than their homes were worth. At the same time, many borrowers lost their jobs and were unable to keep their homes from foreclosure.
Under no circumstances should you think of the proceeds of a closed end home equity loan as “found money.” Make sure you have a serious use of the money before offering your home as collateral. Also, compare loans before you decide on one lender versus another because once you sign your name on the documents, you are committed to its terms. For example, if your closed end home equity loan has a variable rate, make sure you know how often and how much your payments can be raised.
Bill Herrfeldt specializes in finance, sports and the needs of retiring people, and has been published in the national edition of "Erickson Tribune," the "Washington Post" and the "Arizona Republic." He graduated from the University of Louisville.