What is a 'Home-Equity Loan'

A home-equity loan, also known as an "equity loan," a home-equity installment loan, or a second mortgage, is a type of consumer debt. It allows home owners to borrow against their equity in the residence. The loan is based on the difference between the homeowner's equity and the home's current market value. Essentially, it is a mortgage, and it also provides collateral for an asset-backed security issued by the lender and tax deductible interest payments for the borrower. As with any mortgage, if the loan is not paid off, the home could be sold to satisfy the remaining debt.

Home-equity loans exploded in popularity after the Tax Reform Act Of 1986, as they provided a way for consumers to somewhat circumvent one of its main provisions, which eliminated deductions for the interest on most consumer purchases. The big exception: interest in the service of residence-based debt. Today, with a home-equity loan, homeowners can borrow up to $100,000 and still deduct all of the interest when they file their tax returns (assuming they make itemized deductions).

How Big are Home-Equity Loans?

How much someone can borrow is partially based on a combined loan-to-value (CLTV) ratio of 80% to 90% of the home’s appraised value. The amount of the loan, as well as the rate of interest charged, will of course also depend on the borrower’s credit score and payment history.

BREAKING DOWN 'Home-Equity Loan'

Home-equity loans come in two varieties – fixed-rate loans and lines of credit. Fixed-rate 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. They must be repaid in full if the home on which they are based is sold.
 

Benefits for Consumers

Home-equity loans provide an easy source of cash. Obtaining one 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 credit worthiness and the combined loan-to-value ratio.

The interest rate on a home-equity loan – although higher than that of a first mortgage – is much lower than that on credit cards and other consumer loans. As such, the number one reason consumers borrow against the value of their homes via a fixed-rate home-equity loan is to pay off credit card balances (according to bankrate.com). Interest paid on a home-equity loan is also tax deductible, as noted earlier. So, by consolidating debt with the home-equity loan, consumers get a single payment, a lower interest rate and tax benefits.

Benefits for Lenders

Home-equity loans are a dream come true for a lender, who, after earning interest and fees on the borrower's initial mortgage, earns even more interest and fees.  If the borrower defaults, the lender gets to keep all the money earned on the initial mortgage and all the money earned on the home-equity loan; plus the lender gets to repossess the property and sell it again. Even if it didn't finance the first mortgage, the lender is making a secured loan, which can be more advantageous than the typical unsecured or personal loan. From a business-model perspective, it's tough to think of a more attractive arrangement.

The Right Way to Use a Home-Equity Loan

Home-equity loans 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, its low interest rate and tax deductibility makes it sensible alternative.

They're generally a good choice if you know exactly how much you need to borrow and what you’ll use the money for. You’re guaranteed a certain amount, which you receive in full at closing. “Home-equity loans are generally preferred for larger, more expensive goals such as remodeling, paying for higher education or even debt consolidation since the funds are received in one lump sum,” says Richard Airey, a loan officer with Finance of America Mortgage in Portland, Maine. Of course, when applying, there can be some temptation to borrow more than you immediately need, since you only get the payout once, and you don’t know if you’ll qualify for another loan in the future.

Recognizing Pitfalls

The main problem is that home-equity loans can seem to be 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 the lenders have a term for it: reloading, 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's house. This type of loan often comes with higher fees because, as the borrower has taken out more money than the house is worth, the loan is not secured by collateral. Furthermore, the interest paid on the portion of the loan that is above the value of the home is not tax deductible.

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 value of your home? If so, it will likely be unrealistic to expect that you'll be better off when you increase your debt by 25%, plus interest and fees. This could become a slippery slope to bankruptcy.

Shop Around

Because home-equity loans don't involve as large sums as mortgages, it’s easier to compare terms and interest rates. When looking, "don't focus solely on large banks, but instead consider a loan with your local credit union," recommends Movearoo.com Real Estate and Relocation Expert Clair Jones. “Credit unions sometimes offer better interest rates and more personalized account service if you're willing to deal with a slower application processing time.”

As with a mortgage, you can ask for a good faith estimate. But before you do, make your own honest estimate of your finances. Casey Fleming, mortgage advisor at C2 Financial Corporation and author of “The Loan Guide: How to Get the Best Possible Mortgage,” says, “You 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” – and there are no refunds for not qualifying.

Just because it’s for a smaller amount of money doesn’t mean that you won’t go through an application process. According to Sahakian, in addition to providing proof of ownership and equity availability, you will need pay stubs for at least the past month, two years of tax returns, three to six months of bank statements, proof of identity and possibly other documentation.
 

Run the Numbers

If you qualify for the loan, be sure you understand how it works. Traditional home-equity loans have a repayment term, just like regular conventional mortgages. You make regular, fixed payments covering both principal and interest. That's pretty straightforward.

Before signing, though, you should run the numbers with your bank and make sure the loan's 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.

For example, if 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 the vehicle, so if you default on the home-equity loan, your home is at stake, not your car. Losing your home would be significantly more catastrophic.

For that reason alone you should try to pay as much as you can on the loan every month to protect your residence from foreclosure. Before doing something that puts your house in hock (or deeper in hock), weigh all of your options. And if you're getting the loan to pay off plastic, resist the temptation to run up those credit card bills again.
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