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 homeowners to borrow against their equity in the residence. The loan amount is based on the difference between the home's current market value and the homeowner's mortgage balance due.
How a Home Equity Loan Works
Essentially, a home equity loan is a mortgage. Your equity in the home serves as collateral for the lender. The amount a homeowner is allowed to borrow will be partially based on a combined loan-to-value (CLTV) ratio of 80% to 90% of the home’s appraised value. Of course, the amount of the loan, as well as the rate of interest charged, will also depend on the borrower’s credit score and payment history. Traditional home equity loans have a repayment term, just like regular conventional mortgages. You make 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 is a good way to convert the equity you’ve built up in your home into cash. But always remember, you’re putting your home on the line.
Tax Considerations for Home Equity Loans
Home equity loans exploded in popularity after the Tax Reform Act of 1986, as they provided a way for consumers to get around one of its main provisions—the 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. However, the Tax Cuts and Jobs Act of 2017 suspended the deduction for interest paid on home equity loans and lines of credit until 2026, unless, according to the IRS, “they are used to buy, build or substantially improve the taxpayer’s home that secures the loan.” The interest on a home equity loan used to consolidate debts or pay for a child’s college expenses is not tax-deductible.
Home Equity Loans vs. Home Equity Lines of Credit
Home equity loans come in two varieties—fixed-rate loans and home equity lines of credit (HELOC).
Fixed-rate home equity loans provide a single, lump-sum payment to the borrower, which is repaid over a set period of time (generally 5 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, pay back, and then draw on again, for a term determined by the lender. The draw period (5 to 10 years) is followed by a repayment period when draws are no longer allowed (10 to 20 years). HELOCs typically have a variable interest rate, but some lenders may convert to a fixed rate for the repayment period.
Pros and Cons of a Home Equity Loan for Consumers
There are a number of key benefits to home equity loans, including cost. But there are also drawbacks.
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, its low-interest rate and possible tax deductibility make it 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—although higher than that of a first mortgage—is 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’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.
Be aware that home-equity loans can carry risks, too. 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 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 fully secured by collateral. Also, know that interest paid on the portion of the loan that is above the value of the home is never tax deductible.
When applying for a home equity loan, 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.
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’ll be better off when you increase your debt by 25%, plus interest and fees. This could become a slippery slope to bankruptcy and foreclosure.
Questions to Consider When Shopping for a Home Equity Loan
Before you take a home equity loan, be sure 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.
Before signing—especially if you’re using the home equity loan for debt consolidation—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.
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 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.
The Bottom Line on Home Equity Loans
A home equity loan can be a good way to convert the equity you’ve built up in your home into cash, especially if you invest that cash in home renovations that increase the value of your home. But always remember, you’re putting your home on the line: If real estate values decrease, you could end up owing more than your home is worth. Should you then want to relocate, you might end up losing money on the sale of the home or be unable to move. And if you're getting the loan to pay off plastic, resist the temptation to run up those credit card bills again. Before doing something that puts your house in hock (or deeper in hock), weigh all of your options.