A home equity loan, also known as an equity loan, home equity installment loan, or second mortgage, is a type of consumer debt. These loans allow homeowners to borrow against the equity in their homes. The loan amount is based on the difference between the home’s current market value and the mortgage balance due. Home equity loans are typically fixed-rate, differentiating them from home equity lines of credit (HELOCs) which usually have variable rates.
Key Takeaways
- Home equity loans enable homeowners to borrow against the equity in their residence.
- Loan amounts are based on the difference between a home’s current market value and the homeowner’s mortgage balance due.
- Home equity loans come in two varieties: fixed-rate loans and home equity lines of credit (HELOCs).
- Fixed-rate home equity loans provide a single lump sum, whereas HELOCs offer revolving lines of credit.
How a Home Equity Loan Works
A home equity loan is similar to a mortgage. The equity in the home serves as collateral for the lender. The loan amount a homeowner can borrow is based on a combined loan-to-value (CLTV) ratio—usually between 80% to 90% of the home’s appraised value. Factors such as credit score and payment history also influence the loan and interest rate.
Applying for a home equity loan involves multiple steps including credit checks and property appraisal. Ensure that your credit and home value are in good standing to improve the chances of approval.
Like conventional mortgages, traditional home equity loans have set repayment terms, requiring regular, fixed payments covering both principal and interest. Not repaying the loan could result in foreclosure.
Although home equity loans can provide a substantial source of funds, it’s essential to weigh all your options, especially if considering using the loan to pay off credit card debt or for significant purchases. Options like cash-out refinancing could be more suitable depending on your financial situation.
Special Considerations
Home equity loans gained popularity after the Tax Reform Act of 1986 allowed deductions for interest on residence-based debt. However, the 2017 Tax Cuts and Jobs Act suspended this deduction unless the loan is used to buy, build or substantially improve the secured home.
Always make a realistic estimate of your finances before applying. Consult with your lender to ensure monthly payments on the new loan will be lower than your current obligations. Note that only debt consolidation loans used to improve the home qualify for tax deductions.
Home Equity Loans vs. HELOCs
Home equity loans provide a lump-sum payment, while a HELOC functions like a credit card, allowing you to draw upon the credit as needed. HELOCs typically feature variable interest rates but some lenders offer fixed-rate options.
HELOC vs. Home Equity Loan
- Home Equity Loan: Fixed interest rate, lump sum, long repayment period.
- HELOC: Revolving line of credit, variable interest, flexible draw and repayment periods.
Advantages and Disadvantages of a Home Equity Loan
Advantages
Home equity loans offer easy access to funds with lower interest rates compared to credit cards. They are ideal for significant expenses such as home renovation or education due to the fixed receiving amount and interest rates.
Disadvantages
These loans can lead to debt cycles, tempt excessive borrowing and may have higher fees if the loan amount exceeds home value. Be cautious of falling into a reloading cycle. Always borrow only what you need.
Home Equity Loan Requirements
Generally, to get approval for a home equity loan, you’ll need:
- More than 20% equity in your home.
- A verifiable two-year income history.
- A credit score above 600.
While exceptions exist, expect higher interest rates with specialized lenders for high-risk borrowers.
Example of a Home Equity Loan
Suppose you have a $10,000 auto loan at 9% interest with two years remaining. Consolidating it into a home equity loan at 4% for five years would cost you more in the long run. Remember, your home is now collateral.
Frequently Asked Questions (FAQs)
How does a home equity loan work?
A home equity loan uses your home’s equity as collateral and features fixed repayment terms. Unable to repay may result in losing your home.
Are home equity loans tax deductible?
Interest on home equity loans is tax deductible if used to buy, build or improve your home. Post-2017 tax laws may not favor itemizing.
How much home equity loan can I get?
For qualified borrowers, CLTV ratio usually allows loans up to 90% of the home’s appraised value.
Can you have a HELOC and a home equity loan simultaneously?
Yes, provided you meet the lender’s requirements and have sufficient home equity.
What is a HELOC loan?
‘HELOC loan’ is a misnomer. A HELOC and a home equity loan are distinct products.
The Bottom Line
Home equity loans are straightforward for those who know the exact amount they need and prefer a fixed interest rate. Exercise caution and make wise financial decisions to avoid potential pitfalls such as bankruptcy or foreclosure.
Related Terms: Consumer Debt, Collateral, Credit Score, Loan-to-Value Ratio.
References
- Congress.gov, U.S. Congress. “H.R.3838 — Tax Reform Act of 1986”.
- Internal Revenue Service. “Interest on Home Equity Loans Often Still Deductible Under New Law”.
- Internal Revenue Service. “Publication 936: Home Mortgage Interest Deduction”, Pages 9–10.
- Federal Trade Commission, Consumer Advice. “Home Equity Loans and Home Equity Lines of Credit”.
