What Is a Home Equity Loan?

A home equity loan鈥攁lso known as an equity loan, home equity installment loan, or second mortgage鈥攊s a type of consumer debt. Home equity loans allow homeowners to borrow against the equity in their home.聽The loan amount is based on the difference between the home鈥檚 current market value and the homeowner鈥檚 mortgage balance due. Home equity loans tend to be fixed-rate, while the typical alternative, home equity聽lines of credit (HELOCs), generally have variable rates.

Key Takeaways

  • A home equity loan, also known as a 鈥渉ome equity installment loan鈥 or a 鈥渟econd mortgage,鈥 is a type of consumer debt.
  • Home equity loans allow homeowners to borrow against the equity in their residence.聽
  • Home equity loan amounts are based on the difference between a home鈥檚 current market value and the mortgage balance due.
  • Home equity loans come in two varieties鈥攆ixed-rate loans and home equity lines of credit (HELOCs).聽
  • Fixed-rate home equity loans provide one lump sum, whereas HELOCs offer borrowers revolving lines of credit.

How a Home Equity Loan Works

Essentially, a home equity loan is akin to a mortgage, hence the name second mortgage. The equity in the home serves as collateral for the lender. The amount a homeowner is allowed to borrow will be partially based on a聽combined loan-to-value (CLTV) ratio of 80% to 90% of the home鈥檚 appraised value. Of course, the amount of the loan and the rate of interest charged also depend on the borrower鈥檚 credit score and payment history.

Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the or with the (HUD).

Traditional home equity loans have a set repayment term, just like conventional mortgages. The borrower makes regular, fixed payments covering both principal and interest. As with any mortgage, if the loan is not paid off, the home could be sold to satisfy the remaining debt.

A home equity loan can be a good way to convert the equity you鈥檝e built up in your home into cash, especially if you invest that cash in home renovations that increase the value of your home. However, always remember that you鈥檙e putting your home on the line鈥攊f real estate values decrease, you could end up owing more than your home is worth.

Should you want to relocate, you might end up losing money on the sale of the home or be unable to move. And if you鈥檙e getting the loan to pay off credit card debt, resist the temptation to run up those credit card bills again. Before doing something that puts your house in jeopardy, weigh all of your options.

Special Considerations

Home equity loans exploded in popularity after the聽Tax Reform Act of 1986 because they provided a way for consumers to get around one of its main provisions鈥攖he elimination of deductions for the interest on most consumer purchases. The act left in place one big exception: interest in the service of residence-based debt.聽

However, the Tax Cuts and Jobs Act of 2017 suspended the deduction for interest paid on home equity loans and HELOCs until 2026, unless, according to the IRS, 鈥渢hey are used to buy, build, or substantially improve the taxpayer鈥檚 home that secures the loan.鈥 The interest on a home equity loan used to consolidate debts or pay for a child鈥檚 college expenses, for example, is not tax-deductible.

Before you take a home equity loan, be sure to compare terms and interest rates. When looking, 鈥渄on鈥檛 focus solely on large banks, but instead consider a loan with your local聽credit union,鈥 recommends , a real estate and relocation expert who writes for Movearoo.com and iMove.com. 鈥淐redit unions sometimes offer better interest rates and more-personalized account service if you鈥檙e willing to deal with a slower application processing time.鈥

As with a mortgage, you can ask for a聽good faith estimate, but before you do, make your own honest estimate of your finances. , mortgage advisor at C2 Financial Corporation and author of The Loan Guide: How to Get the Best Possible Mortgage, says, 鈥淵ou should have a good sense of where your credit and home value are before applying, in order to save money. Especially on the appraisal [of your home], which is a major expense. If your appraisal comes in too low to support the loan, the money is already spent鈥濃攁nd there are no refunds for not qualifying.

Before signing鈥攅specially if you鈥檙e using the home equity loan for debt consolidation鈥攔un the numbers with your bank and make sure the loan鈥檚 monthly payments will indeed be lower than the combined payments of all your current obligations. Even though home equity loans have lower interest rates, your term on the new loan could be longer than that of your existing debts.

The interest on a home equity loan is only tax deductible if the loan is used to buy, build, or substantially improve the home that secures the loan.

Home Equity Loans vs. HELOCs

Home equity loans provide a single lump-sum payment to the borrower, which is repaid over a set period of time (generally five to 15 years) at an agreed-upon interest rate. The payment and interest rate remain the same over the lifetime of the loan. The loan must be repaid in full if the home on which it is based is sold.

A HELOC is a revolving line of credit, much like a credit card, that you can draw on as needed, payback, and then draw on again, for a term determined by the lender. The draw period (five to 10 years) is followed by a repayment period when draws are no longer allowed (10 to 20 years).聽HELOCs typically have a variable interest rate, but some lenders offer HELOC fixed-rate options.

Advantages and Disadvantages of a Home Equity Loan

There are a number of key benefits to home equity loans, including cost, but there are also drawbacks.

Pros
  • Easy to obtain

  • Lower interest rates than other debt

  • Possible tax deduction for interest paid

Cons
  • Easy to obtain

  • Possible spiraling debt鈥攈ence why "easy to obtain" is also a con

  • Can lead to home foreclosure

Advantages

Home equity loans provide an easy source of cash and can be valuable tools for responsible borrowers. If you have a steady, reliable source of income and know that you will be able to repay the loan, low-interest rates and聽possible tax deductions make home equity loans a sensible choice.

Obtaining a home equity loan is quite simple for many consumers because it is a secured debt. The lender runs a credit check and orders an appraisal of your home to determine your creditworthiness and the combined loan-to-value ratio.

The interest rate on a home equity loan鈥攁lthough higher than that of a first mortgage鈥攊s much lower than that on credit cards and other consumer loans. That helps explain why the primary reason consumers borrow against the value of their homes via a fixed-rate home equity loan is to pay off credit card balances.

Home equity loans are generally a good choice if you know exactly how much you need to borrow and what you鈥檒l use the money for. You鈥檙e guaranteed a certain amount, which you receive in full at closing. 鈥淗ome equity loans are generally preferred for larger, more expensive goals such as remodeling, paying for higher education, or even聽debt consolidation, since the funds are received in one lump sum,鈥 says , a loan officer with First Financial Mortgage in Portland, Maine.

Disadvantages

The main problem with home equity loans is that they can seem an all-too-easy solution for a borrower who may have fallen into a perpetual cycle of spending, borrowing, spending, and sinking deeper into debt. Unfortunately, this scenario is so common that lenders have a term for it:聽鈥reloading,鈥 which is basically the habit of taking out a loan in order to pay off existing debt and free up additional credit, which the borrower then uses to make additional purchases.

Reloading leads to a spiraling cycle of debt that often convinces borrowers to turn to home equity loans offering an amount worth 125% of the equity in the borrower鈥檚 house. This type of loan often comes with higher fees because鈥攁s the borrower has taken out more money than the house is worth鈥攖he loan is not fully secured by collateral. Also, know that interest paid on the portion of the loan that is above the value of the home is聽never tax-deductible.

When applying for a home equity loan, there can be some temptation to borrow more than you immediately need, as you only get the payout once, and you don鈥檛 know if you鈥檒l qualify for another loan in the future.

If you are contemplating a loan that is worth more than your home, it might be time for a reality check. Were you unable to live within your means when you owed only 100% of the equity in your home? If so, it will likely be unrealistic to expect that you鈥檒l be better off when you increase your debt by 25%, plus interest and fees. This could become a slippery slope to聽bankruptcy and聽foreclosure.

Example of a Home Equity Loan

Say you have an auto loan with a balance of $10,000 at an interest rate of 9% with two years remaining on the term. Consolidating that debt to a home equity loan at a rate of 4% with a term of five years would actually cost you more money if you took all five years to pay off the home equity loan. Also, remember that your home is now collateral for the loan instead of your car. Defaulting could result in its loss, and losing your home would be significantly more catastrophic then surrendering a car.