Home Equity

A home equity loan is a type of loan in which the borrower uses the equity in their home as collateral.  These loans are sometimes useful to help finance major home repairs, medical bills or college education.  A home equity loan creates a lien against the borrower's house and reduces actual home equity.

Home equity loans are most commonly second position liens (second trust deed), although they can be held in first or, less commonly, third position. Most home equity loans require good to excellent credit history and reasonable loan-to-value and combined loan-to-value ratios.  Home equity loans come in two types, closed end and open end.

Both are usually referred to as second mortgages, because they are secured against the value of the property, just like a traditional mortgage.  Home equity loans and lines of credit are usually, but not always, for a shorter term than first mortgages.  In the United States, it is sometimes possible to deduct home equity loan interest on one's personal income taxes.

Closed-End Home Equity Loan

The borrower receives a lump sum at the time of the closing and cannot borrow further.  The maximum amount of money that can be borrowed is determined by variables including credit history, income, and the appraised value of the collateral, among others.  It is common to be able to borrow up to 100% of the appraised value of the home, less any liens, although there are lenders that will go above 100% when doing over-equity loans.  However, state law governs in this area; for example, Texas (which was, for many years, the only state to not allow home equity loans) only allows borrowing up to 80% of equity.

Closed-end home equity loans generally have fixed rates and can be amortized for periods usually up to 15 years.  Some home equity loans offer reduced amortization whereby at the end of the term, a balloon payment is due.  These larger lump-sum payments can be avoided by paying above the minimum payment or refinancing the loan.

 Open End Home Equity Loan

This is a revolving credit loan, also referred to as a home equity line of credit (HELOC), where the borrower can choose when and how often to borrow against the equity in the property, with the lender setting an initial limit to the credit line based on criteria similar to those used for closed-end loans.  Like the closed-end loan, it may be possible to borrow up to 100% of the value of a home, less any liens. These lines of credit are available up to 30 years, usually at a variable interest rate.  The minimum monthly payment can be as low as only the interest that is due.

Typically, the interest rate is based on the Prime rate plus a margin.

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Construction

Short-term real estate loan to finance building costs. The funds are disbursed as needed or in accordance with a prearranged plan, and the money is repaid on completion of the project, usually from the proceeds of a mortgage loan. The rate is normally higher than prime, and there is usually an origination fee. The effective yield on these loans tends to be high, and the lender has a security interest in the real property.

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Seconds

A second mortgage is subordinate to the lien created by a first mortgage, but senior to subsequent liens. Sometimes called a second trust, a second mortgage normally has a repayment term much shorter than a first mortgage, a fixed amortization schedule, and may have a balloon payment.  The holder of a second mortgage has rights secondary to the holder of a first mortgage lien in event of foreclosure.  In a second mortgage, interest due is computed on the entire principal balance owed, which is advanced to the borrower after the required three-day rescission period.  A second mortgage is, in effect, an installment loan secured by the borrower's real estate, and technically, a closed-end credit arrangement with a predetermined repayment table or amortization schedule.

Second mortgages are used for a variety of borrowing needs, including home improvement, investment in a business, and raising cash.  Second mortgages also are commonly used to make a smaller down payment in a first mortgage if taken out when a home is purchased.

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Adjustable Rate

Adjustable rate mortgages (ARMs) are loans in which the interest rate is periodically adjusted, moving higher or lower in the same ratio as a preselected index, such as Treasury bill rates.  ARM loans may include caps on interest rate increases in a given time period, and over the life of the loan, and may include limits on the frequency of interest rate adjustments.  ARM loans generally have initial below market interest rates in return for the borrower sharing the risk that interest rates may rise during the life of the loan.

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Fixed Rate

A fixed rate mortgage (FRM) is a mortgage loan in which the interest rate on the note remains the same through the term of the loan, as opposed to loans where the interest rate may adjust or "float."  Fixed rate mortgages are characterized by their interest rate (including compounding frequency, amount of loan, and term of the mortgage).  With these three values, the calculation of the monthly payment can then be done.  Unlike adjustable rate mortgages, fixed rate mortgages are not tied to an index.  Instead, the interest rate is set (or "fixed") in advance to an advertised rate, usually in increments of 1/4 or 1/8 percent.

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