What Is a Home Equity Loan?

A home equity loan, also known as an equity loan, home equity installment loan, or second mortgage, is a type of consumer debt that allows homeowners to borrow against the equity in their homes. The loan amount is determined based on the difference between the home’s current market value and the homeowner’s mortgage balance due. While home equity loans generally have fixed rates, the alternative option, home equity lines of credit (HELOCs), typically feature variable rates.

How a Home Equity Loan Works?

A home equity loan is similar to a mortgage, hence its other name, second mortgage. The equity in the home serves as collateral for the lender. Homeowners can typically borrow up to 80% to 90% of the home’s appraised value, less the balance owed on the primary mortgage. The loan amount and interest rate depend on the borrower’s credit score and payment history.

Traditional home equity loans have set repayment terms, similar to conventional mortgages. Borrowers make regular, fixed payments that cover both principal and interest. If the loan is not repaid, the home could be sold to satisfy the remaining debt.

Home equity loans can be an effective way to convert the equity in your home into cash, especially for home renovations that increase the home’s value. However, they come with the risk of losing your home if real estate values decrease or if you fail to make payments.

If you plan to use a home equity loan to pay off credit card debt, it’s crucial to avoid running up those bills again. Weigh all your options carefully before putting your home on the line.

Marguerita Cheng, a Certified Financial Planner, advises: “If considering a home equity loan for a large amount, be sure to compare rates on multiple loan types. A cash-out refinance may be a better option than a home equity loan, depending on how much you need.”

Special Considerations:

Home equity loans became popular after the Tax Reform Act of 1986, which eliminated deductions for interest on most consumer purchases but allowed deductions for interest on residence-based debt. However, the Tax Cuts and Jobs Act of 2017 suspended the deduction for interest paid on home equity loans and HELOCs until 2026, unless used to buy, build, or substantially improve the home that secures the loan.

Before applying for a home equity loan, make an honest estimate of your finances and creditworthiness. Casey Fleming, author of The Loan Guide: How to Get the Best Possible Mortgage, suggests having a good sense of your credit and home value to avoid unnecessary expenses, such as appraisal fees.

When using a home equity loan for debt consolidation, ensure the new loan’s monthly payments are indeed lower than your current obligations. Although home equity loans typically have lower interest rates, the loan term could be longer than your existing debts.

Advantages of Home Equity Loans:

Home equity loans offer several benefits, making them a valuable financial tool for responsible borrowers:

Source of Cash: They provide an easy source of cash, which can be used for significant expenses like home renovations or higher education.
Lower Interest Rates: The interest rates on home equity loans are generally lower than those on credit cards and other consumer loans.
Tax Deductions: If used to buy, build, or substantially improve the home, the interest may be tax-deductible.
Fixed Payments: Home equity loans come with fixed interest rates and regular payments, providing predictability.
High Loan Amounts: They can be ideal for large expenses as you receive a lump sum at closing.

Disadvantages of Home Equity Loans:

Despite the benefits, home equity loans also have drawbacks that borrowers should consider:

Risk of Debt Cycle: They can lead to a cycle of spending, borrowing, and increasing debt, especially if the borrower continues to spend beyond their means.
Reloading: This habit of taking out a loan to pay off existing debt and then running up additional debt can result in financial instability.
Higher Fees: Loans exceeding the home’s value often come with higher fees and are not fully secured by the home.
Temptation to Overborrow: Borrowing more than needed can be tempting, but it increases the risk of financial strain and potential foreclosure.
Loss of Home Value: If home values decrease, borrowers might owe more than the home’s worth, complicating potential sales or relocations.

Key Takeaways:

Definition: A home equity loan, or second mortgage, is a type of consumer debt that allows homeowners to borrow against the equity in their residence.
Borrowing Basis: The loan amount is based on the difference between a home’s current market value and the mortgage balance.
Varieties: Home equity loans come in two types: fixed-rate loans and home equity lines of credit (HELOCs).
Fixed-Rate Loans: These provide a lump sum with a fixed interest rate and regular payments.
HELOCs: These offer revolving lines of credit with variable rates, allowing borrowing as needed.

Home Equity Lines of Credit (HELOCs):

HELOCs differ from home equity loans in that they offer a revolving line of credit, similar to a credit card. Borrowers can draw on this line of credit as needed, repay it, and draw again during the draw period, which typically lasts five to 10 years. This is followed by a repayment period of 10 to 20 years when draws are no longer allowed. HELOCs usually have variable interest rates, though some lenders offer fixed-rate options.

Final Thoughts:

Home equity loans can be a powerful financial tool, offering access to substantial funds at lower interest rates than other types of credit. They are particularly useful for significant expenses like home renovations, education, or debt consolidation. However, the risk of losing your home if you fail to make payments or if property values decline is significant. Always consider your financial stability and future market conditions before taking out a home equity loan.

For larger financial decisions, consulting a financial advisor or mortgage professional can provide valuable insights and help you navigate the complexities of home equity loans and HELOCs. By making informed choices and managing your finances responsibly, you can leverage the equity in your home to achieve your financial goals.