How Does Home Equity Loan Interest Work?

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    What is a home equity loan?

    • A home equity loan is a loan that a homeowner takes out against the value of his home, which he owns. Essentially, a home equity loan is a second mortgage that is usually put on a house where the first mortgage has been paid consistently for many years and quite possibly has been paid off in full. The purpose of a home equity loan is to gain access to a large amount of credit from a bank for purposes such as buying a car, remodeling a home, education or unexpected expenses. In exchange for the loan, the homeowner puts a lien against the home, meaning it is offered as collateral that can be seized in the event of nonpayment.

    Home equity loan interest is paid to the bank

    • As with all loans, a home equity loan requires the homeowner to pay interest to the lender for the duration of the loan until it is paid off in full. A home equity loan should not be confused with a reverse mortgage, which is when a bank provides periodic income to the homeowner, and all payments as well as interest are added to a lien against the home. The duration of home equity loans are typically shorter than traditional mortgages (since the amount borrowed is usually less), so the interest rates charged are normally lower than a first mortgage. Interest is accrued on the amount of outstanding principle owed, and for some home equity loans, the minimum payment can cover as little as the amount interest owed.

    Benefits and drawbacks of home equity loans

    • A primary benefit of a home equity loan is that it allows a homeowner who has built up equity to access money quickly should the need arise, at a reasonable interest rate. This can potentially rescue a homeowner in the event of unforeseen financial burdens. There are, however, several drawbacks to home equity loans. For one, the applicant must typically have a very good credit rating in order to be approved and must have built a significant amount of equity in her home. Another drawback is that the loan turns assets owned by the borrower into a liability owned to the bank, on which interest must be paid. Additionally, securing a home equity loan often requires payment of numerous fees that further add to the cost of paying off the loan.

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