A home equity loan, also known as a second mortgage, lets homeowners borrow money by leveraging the equity value in their homes. Home equity loans exploded in popularity in the late 1980s, as they provided a way to somewhat circumvent the Tax Reform Act of 1986, which eliminated deductions for the interest on most consumer purchases. With a home equity loan, homeowners could deduct all of the interest when they file their tax returns.
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The problem for homeowners is that this tax-deduction bliss did not last. The Tax Cuts and Jobs Act of 2017 removed the home equity loan tax deduction starting in 2018, except if you use the money for qualified home renovations (the phrase in the law is “buy, build, or substantially improve” the home that secured the loan).
There are, nonetheless, still several other good reasons to take out home equity loans, such as their relatively low interest rates compared with other loans, but a tax deduction may no longer be in the cards for them.
- A home equity loan allows you to tap into the equity in your home and use it as cash.
- There are two main types of home equity loans: fixed-rate loans and home equity lines of credit (HELOCs).
- The interest paid on home equity loans is tax-deductible, but only if the loan is used to buy, build, or substantially improve the home that secured the loan.
- Both types of loans must be repaid in full if the home on which they are borrowed is sold.
How Do Home Equity Loans Work?
Fixed-rate loans provide a single, lump-sum payment to the borrower, which is repaid over a set period of time, usually five to 15 years, at an agreed-upon interest rate. The payment and interest rate remain the same over the lifetime of the loan.
Home Equity Lines of Credit (HELOCs)
A home equity line of credit (HELOC) is an adjustable or variable-rate loan that works much like a credit card and, in fact, sometimes comes with one to use for purchases on the line of credit. Borrowers are pre-approved for a certain spending limit and can withdraw money when they need it via a credit card or special checks.
Monthly payments vary based on the amount of money borrowed and the current interest rate. The draw period, usually five to 10 years, is followed by a repayment period when draws are no longer allowed, generally 10 to 20 years. Though HELOCs typically have a variable interest rate, some lenders may convert to a fixed rate for the repayment period.
Popular usages for home equity loans include paying off credit cards, home improvements, and paying for college.
Benefits for Consumers
Home equity loans provide an easily accessible source of available cash. The interest rate on a home equity loan—although typically higher than that of a first mortgage—is still much lower than the rates on credit cards and other consumer loans. Indeed, a popular reason consumers have for borrowing against the value of their homes via a fixed-rate home equity loan is to pay off credit card balances.
By consolidating debt with a home equity loan, consumers get a single payment and a lower interest rate, though no more tax benefits.
Benefits for Lenders
Home equity loans are also a dream come true for the lender. After earning interest income and fees on the borrower’s initial mortgage, the lender earns even more interest and fees on the home equity debt. If the borrower defaults, the lender not only gets to keep all the money earned on both the initial mortgage and the home equity loan; it also gets to repossess the property, sell it again, and restart the cycle with the next borrower. From a business-model perspective, it is tough to think of a more attractive arrangement.
If you default on a home equity loan, you could end up losing your collateral—your home.
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 makes it a sensible alternative.
Fixed-rate home equity loans can help cover the cost of a single, large purchase, such as a new roof on your home or an unexpected medical bill. A HELOC provides a convenient way to cover short-term recurring costs, such as the quarterly tuition for a four-year degree at a college.
Recognizing the Pitfalls
The main pitfall associated with home equity loans is that they sometimes seem to be an easy solution for a borrower who may have fallen into a perpetual cycle of spending and borrowing, spending and borrowing—all the while sinking deeper into debt.
Unfortunately, this scenario is so common that lenders have a term for it: “reloading,” which is basically the habit of taking a loan in order to pay off existing debt and free up additional credit, which the borrower then uses to make additional purchases. Reloading can lead 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.
If you are contemplating a loan that is worth more than your home, it might be time for a financial 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.
Another pitfall may arise when homeowners take out a home equity loan to finance home improvements. While remodeling the kitchen or bathroom generally adds value to a house, improvements such as a swimming pool may be worth more in the eyes of the homeowner than in the market. If you’re going into debt to make changes to your house, try to determine whether the changes add enough value to cover their costs.
Paying for a child’s college education is another popular reason for taking out a home equity loan. However, especially if borrowers are nearing retirement, they need to determine how the loan may affect their ability to accomplish their goals. It may be wise for near-retirement borrowers to seek out other options. Note that either type of home equity loan must be repaid immediately in full if the home against which they are borrowed is sold.
The Bottom Line
Food, clothing, and shelter are life’s basic necessities, but only shelter can be leveraged for cash. Despite the risk involved, it is easy to be tempted into using home equity to splurge on discretionary items. On the other hand, in a financial crisis, home equity can be a source of lower-interest cash.
To avoid the pitfalls of reloading, conduct a careful review of your financial situation before you borrow against your home. Make sure you understand the home equity loan terms and have the means to make the payments and comfortably repay the debt on or before its due date without compromising other bills.
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 Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).