A home equity loan is merely a loan given by the bank

In general, banks make equity loans in exchange for a security interest in collateral, usually real estate. Because banks may recover through foreclosure their losses in the event of default on the part of the borrower, equity loans usually carry lower interest rates than unsecured loans, like credit cards. Most non-commercial borrowers learn about equity loans in the context of home equity loans.

As implied in the name, a home equity loan is merely a loan given by the bank in exchange for the bank’s right to foreclose on the home if the homeowner defaults. Sometimes called second mortgages, banks make these loans in exchange for some portion of the homeowner’s equity interest in the home. Loan rates for home equity loans that exceed the homeowner’s equity interest in the home offer a larger loan amount but generally carry higher rates as well.

A home equity loan is merely a loan given by the bank

Equity loan rates will vary according to the market rates at the time. Most banks determine their equity loan rates by using the current Prime Rate, or the rate at which lenders, in theory, are willing to lend to their best commercial customers for short-term loans, as a reference point. Rate cuts or increases made by the Federal Reserve affect the Prime Rate and thus can indicate whether home equity loan rates will fall or rise.

Equity loan rates may also vary from borrower to borrower depending upon the lending bank’s assessment of the borrower’s risk for default. Banks generally prefer to make money on loan interest and fees rather than on foreclosure. If a borrower has a low credit score and a pattern of reloading, or paying off purchases made on credit by acquiring more credit, then the bank may determine that the borrower constitutes a high risk for defaulting on the loan. In that event, the bank may refuse to make the loan or may offer the loan at higher rates than equity loans offered at the same time to borrowers with better credit management histories.

A bank may make equity loans according to a fixed-rate or a line of credit structure.

Both carry the possibility of foreclosure on the collateral real property. However, depending upon whether the bank made a fixed-rate equity loan to the borrower or simply opened a line of credit for the borrower, equity loan rates may also vary during the life of the loan term. The life of the loan term begins when the bank makes the loan and ends when full repayment is due.

In a true fixed-rate equity loan, the loan rate is fixed at the time the loan is made and remains unchanged throughout the life of the loan regardless of other circumstances that may occur during the loan term. If you are in the process of taking out a fixed-rate equity loan, however, make sure to read the loan documents carefully. Some mortgages advertised as fixed-rate mortgages may include conditions that allow the bank to raise the equity loan rate if certain events occur. Fixed-rate equity loans give the loan amount to the borrower in a lump sum at the beginning of the loan term. The borrower then makes periodic repayments, plus interest, until the borrower has fully paid the loan by the end of the loan term.

An equity line of credit is similar to a fixed rate equity loan in that the borrower secures his interest in the amount loaned by taking the borrower’s equity in real property as collateral for the loan. However, an equity line of credit is different in that the borrower does not receive a lump sum up front. Rather, the bank gives the borrower an amount of credit with the bank. The borrower can take out amounts up to, but not exceeding the credit amount, during the life of the loan term. At the end of the loan term, the borrower must repay only the amount actually borrowed plus interest and fees. Instead of fixing a loan rate based on market rates at the time, the bank ties the loan rate to a particular market rate (e.g., LIBOR), similar to the rate structure of a credit card. Thus the actual loan rate may vary throughout the life of the loan as the underlying market rate fluctuates.

After the sub-prime mortgage crisis that eventually, in September 2008, resulted in the bankruptcy and fire-sale of several banks and insurers, banks have shown a general hesitancy to lend. This hesitancy is referred to as the “credit crunch” and seems to be relatively independent of borrower credit history. The bailout plans formulated by the executive branch and congress have the goal of pumping cash into the monetary system so that banks will decide to start making more loans again.