What Is a Home Equity Loan?

A home equity loan is a type of consumer debt that is also known as an equity loan, home equity installment loan, or second mortgage. Home equity loans enable homeowners to borrow against their homes' equity. The loan amount is determined by the gap between the current market value of the home and the homeowner's total mortgage balance. The typical alternative to home equity loans as fixed interest rate, home equity lines of credit (HELOCs), typically has variable interest rates.

• A home equity loan is a form of consumer debt, also known as a home equity installment loan or a second mortgage.

• Home equity loans enable homeowners to borrow against their home's equity.

• The amount of a home equity loan is determined by the difference between the home's current market value and the homeowner's outstanding mortgage balance.

• Fixed-rate loans and Home equity lines of credit (HELOCs) are the two main types of home equity loans

• Fixed-rate home equity loans provide borrowers with a lump sum, whereas HELOCs offer revolving credit lines.

Home Equity Loan

How a Home Equity Loan Works

A home equity loan is essentially similar to a mortgage, hence the term "second mortgage." The home's equity acts as collateral for the lender. The maximum amount a homeowner can borrow will be determined in part by a combined loan-to-value (CLTV) ratio between 80% and 90% of the home's appraised value. Obviously, the loan amount and interest rate charged depend on the borrower's credit score and payment history.

Traditional home equity loans, like conventional mortgages, have a fixed repayment period. The borrower makes consistent, fixed principal and interest payments. Similar to any other mortgage, if the loan is not repaid, the home could be sold to cover the remaining balance.

A home equity loan can be a good way to convert your home's equity into cash, especially if you invest the money in home improvements that increase the property's value. However, keep in mind that you could end up owing more than your home is worth if real estate values fall.

If you decide to move, you may lose money on the sale of your home or be unable to relocate. And if you're taking out the loan to pay off credit card debt, resist the urge to run up your credit card bills again. Before putting your home in jeopardy, you should consider all of your options.

"When considering a large home equity loan, be sure to compare interest rates on multiple loan types. Depending on the amount you require, a cash-out refinance may be preferable to a home equity loan.

Certified Financial Planner Marguerita Cheng, Blue Ocean Global Wealth

Special Considerations

After the Tax Reform Act of 1986, home equity loans exploded in popularity because they allowed consumers to circumvent one of its key provisions: the elimination of interest deductions for most consumer purchases. The act preserved one significant exception: interest on the servicing of home-based debt.

The Tax Cuts and Jobs Act of 2017 postponed the deduction for interest paid on home equity loans and HELOCs until 2026, unless, according to the Internal Revenue Service (IRS), "they are used to purchase, construct, 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, for instance, is not tax deductible.

As with a mortgage, you can request a good faith estimate, but before you do so, you should make your own honest financial estimate. Casey Fleming, the branch manager at Fairway Independent Mortgage Corp. and also the author of The Loan Guide: How to Get the Best Possible Mortgage, advises, "To save money, you should have a good understanding of your credit score and home's value before applying." "Especially on the appraisal, which is a significant expense. If your appraisal is too low to support the loan, the funds have already been spent, and there are no refunds for failing to qualify.

Before signing—especially if you're using the home equity loan for debt consolidation—verify with your bank that the loan's monthly payments will be lower than the sum of your current payments. Even though home equity loans have lower interest rates, the new loan could have a longer term than your existing debts.

The interest on a home equity loan is only tax deductible if the loan is used to purchase, construct, or substantially improve the home that serves as collateral for the loan.

Home Equity Loans vs. Home Equity Lines of Credit

Home equity loans provide the borrower with a lump-sum payment that is repaid over a set period of time (generally five to fifteen years) and at an agreed-upon interest rate. Over the life of the loan, both the payment and interest rate remain unchanged. The loan must be repaid in full upon the sale of the property on which it is based.

A HELOC is a revolving line of credit, similar to a credit card, that you can use as needed, repay, and then use again for a lender-determined term. The draw period (five to ten years) is followed by a repayment period during which no further draws are permitted (10 to 20 years). Most HELOCs have variable interest rates, but some lenders offer fixed-rate HELOCs.

Advantages and Disadvantages of Home Equity Loan

There are numerous benefits to home equity loans, including the low cost, but there are also disadvantages.

Advantages

Home equity loans are a convenient source of cash and can be useful tools for dependable borrowers. If you have a steady source of income and are confident that you will be able to repay the loan, home equity loans are a wise choice due to their low interest rates and potential tax benefits.

As a secured debt, obtaining a home equity loan is relatively simple for many consumers. To determine your creditworthiness and the CLTV, the lender runs a credit check and orders an appraisal of your home.

Although higher than that of a first mortgage, the interest rate on a home equity loan is significantly lower than that of credit cards and other consumer loans. This helps explain why one of the primary reasons consumers obtain a home equity loan with a fixed interest rate is to pay off credit card balances.

If you know exactly how much you need to borrow and for what purpose, home equity loans are a good option. You receive the guaranteed amount in full at closing. According to Richard Airey, senior loan officer with Integrity Mortgage LLC in Portland, Maine, "home equity loans are generally preferred for larger loan amount, more expensive goals such as remodeling, paying for higher education, and even debt consolidation"

Disadvantages

The primary issue with home equity loans is that they can appear to be an all-too-simple solution for borrowers who have fallen into a cycle of spending, borrowing, spending, and accumulating more debt. Unfortunately, this situation is so common that lenders have a term for it: reloading, which is the practice of taking out a loan to pay off existing debt as well as free up additional credit, which is then used to make additional purchases.

Reloading leads to a debt spiral that often convinces borrowers to obtain home equity loans for an amount equal to 125% of the equity in their home. This type of loan typically carries higher fees: Due to the fact that the borrower has borrowed more than the home is worth, the loan is not fully secured by collateral. Additionally, note that the interest paid on the portion of the loan that exceeds the home's value is never tax deductible.

There is a temptation to borrow more than you need when applying for a home equity loan because you only receive the payout once and you do not know if you will qualify for another loan in the future.

If you are contemplating a loan greater than the value of your home, it may be time for a dose of realism. Were you unable to live within your means when you owed 100 percent of your home's equity? If so, it is improbable that you will be better off after increasing your debt by 25% plus interest and fees. This situation could lead to bankruptcy and foreclosure.

Home Equity Loan Requirements

To qualify for a home equity loan, most borrowers will typically need the following:

• At least 20% equity in their home;

• Two or more years of verifiable income; and

• A credit score above 600.

Although it is possible to qualify for a home equity loan without meeting these requirements, you should expect to pay a significantly higher interest rate from a lender who specializes in high-risk borrowers.

Find a statement or visit your lender's website to determine the current balance of your mortgage and also any existing second mortgages, home equity lines of credit, or home equity loans. Estimate the current value of your home by comparing it to recent sales in your area or by using a site like Zillow or Redfin. Be aware that their estimates of value are not always accurate, so make any necessary adjustments based on the current condition of your home. Then, divide the current balance of all loans on your property by the property's current estimated value to determine your current equity percentage.

Home Equity Loan woks

The rates assume a $40,000 loan amount and an 80% loan-to-value ratio. The interest rate on a home equity line of credit (HELOC) is based on the rate at the time of the credit line's inception; thereafter, rates are subject to change based on market conditions.

Example of a Home Equity Loan

Consider an auto loan with a $20,000 balance, a 9% interest rate, and two years remaining on the term. Consolidating this debt into a home equity loan with a 4% interest rate and a five-year term would cost you more if you took the full term to repay the home equity loan. Remember that your home now serves as collateral for the loan instead of your automobile. If you default on your mortgage, you risk losing your home, which would be significantly more devastating than losing your vehicle.

How do home equity loans operate?

A home equity loan is a loan for a specified amount of money, repaid over a specified period of time, with the equity in your home serving as collateral. If you cannot repay the loan, you risk losing your home to foreclosure.

Are home equity loans tax deductible?

Interest paid on a home equity loan that is used to "buy, build, or substantially improve" a home is tax deductible. The Due to the Tax Cuts and Jobs Act and also the increased standard deduction, itemizing to deduct the interest paid on the home equity loan may not result in savings for the majority of filers.

How much home equity can I borrow?

The maximum amount of a home equity loan for well-qualified borrowers is the amount necessary to achieve a combined loan-to-value (CLTV) of 90% or less.  This means that the sum of the mortgage, any existing HELOCs, if any existing home equity loans, and also the new home equity loan cannot exceed 90 percent of the home's appraised value. If approved, a homeowner with a home appraised at $500,000 and an existing mortgage balance of $200,000 could obtain a home equity loan for up to $250,000.

Can you simultaneously hold a HELOC and a home equity loan?

Yes. You can have both a HELOC and a home equity loan if you have sufficient equity in your home, sufficient income, and good credit to qualify for both.

What is a home equity line of credit (HELOC) loan?

A HELOC loan doesn't exist. Combining two existing loan products: a home equity line of credit (HELOC) and a home equity loan.

The Bottom Line

Financially, a home equity loan may be a better option than a HELOC for those who know the exact amount of equity they need to withdraw and desire the security of a fixed interest rate. When consolidating debt or financing home repairs, borrowers should approach home equity loans with caution. It is simple to end up underwater on a mortgage if too much equity is withdrawn, leaving a borrower with ruined credit and a foreclosed home.