A home equity loan is a type of consumer debt. It is also known as an equity loan, a home equity payment loan, or a second mortgage. Home equity loans let people use the value of their homes as collateral to borrow money.
The amount of the loan is based on the difference between what the home is worth on the market right now and how much the homeowner still owes on their mortgage. Most home equity loans have set rates, while most home equity lines of credit (HELOCs) have rates that change over time.
KEY TAKEAWAYS
- A home equity loan is a type of consumer debt. It is also called a home equity payment loan or a second mortgage. Home equity loans let people borrow money against the value of their home.
- The amount of a home equity loan is based on the difference between how much the home is worth on the market right now and how much the homeowner still owes on their mortgage.
- Fixed-rate loans and home equity lines of credit (HELOCs) are the two types of home equity loans.
- Fixed-rate home equity loans give you a lump sum, while HELOCs give you a line of credit that you can use over and over again.
How a second mortgage works
A home equity loan is a lot like a mortgage, which is why it’s called a “second mortgage.” The value of the home is used as security for the loan. A combined loan-to-value (CLTV) number of 80% to 90% of the home’s estimated value will help determine how much a renter can borrow. The borrower’s credit score and payment history will also affect the amount of the loan and the interest rate.
Discrimination in mortgage loans is against the law. There are things you can do if you think you’ve been treated unfairly because of your race, religion, sex, marriage status, use of public support, national origin, disability, or age. One step is to tell the Consumer Financial Protection Bureau or the U.S. Department of Housing and Urban Development about what happened.
Like regular mortgages, traditional home equity loans have a set amount of time to pay them back. The user makes set payments on a regular schedule that cover both the debt and the interest. As with any mortgage, if the loan isn’t paid off, the house could be sold to pay off the rest of the debt.
A home equity loan can be a good way to turn the equity you’ve built up in your home into cash, especially if you use the money to make improvements to your home that raise its value. But keep in mind that you could end up paying more than your home is worth if real estate prices go down.
If you wanted to move, you might lose money on the sale of your home or not be able to do so. And if you are taking out the loan to pay off credit card debt, don’t use your credit cards again. Think about all your choices before you do something that could put your house at risk.
Things to think about
After the Tax Reform Act of 1986, the number of people taking out home equity loans went through the roof. This is because they were a way for people to get around one of the law’s main parts, which got rid of interest benefits for most consumer purchases. One big thing was left out of the act, though: interest on debts tied to a home.
Before you sign, run the numbers with your bank, especially if you’re using the home equity loan to pay off debt. Make sure that the loan’s monthly payments will be less than the total of all your present payments. Even though the interest rates on home equity loans are lower than those on other loans, the term of the new loan could be longer than that of your other loans.
The interest on a home equity loan is tax-deductible only if the loan is used to buy, build, or make major changes to the home that is used as collateral for the loan.
Home Equity Loans vs. HELOCs
Home equity loans give the user a single lump-sum payment that is paid back over a set amount of time (usually five to fifteen years) and at an agreed-upon interest rate. Over the life of the loan, both the payment and the interest rate stay the same. If the house that the loan was based on is sold, the loan must be paid back in full.
A HELOC is a rolling line of credit, like a credit card, that you can use as needed, pay back, and then use again for a time set by the lender. After the draw period (5–10 years), there is a payback time (10–20 years) during which draws are not allowed. Most HELOCs have interest rates that change over time, but some lenders offer fixed-rate HELOCs.
What are the pros and cons of a home equity loan?
There are pros and cons to home equity loans, but cost is one of the most important pros.
Advantages
Home equity loans are an easy way to get cash and can be useful tools for people who take them responsibly. Home equity loans are a good choice if you have a steady source of income and know you can pay back the loan. Low interest rates and possible tax credits make home equity loans a good choice.
Many people find it easy to get a home equity loan because it is a protected debt. The lender checks your credit and gets an evaluation of your home to figure out how good your credit is and what your CLTV is.
Even though the interest rate on a home equity loan is higher than that on a first mortgage, it is much lower than that on credit cards and other market loans. This helps explain why one of the main reasons people take out fixed-rate home equity loans against the value of their homes is to pay off credit card debt.
Disadvantages
The main problem with home equity loans is that they can seem like an easy way out for a borrower who has fallen into a loop of spending, borrowing, spending, and getting deeper into debt. Unfortunately, this happens so often that lenders have a word for it: “reloading.” This is the habit of taking out a loan to pay off other debts and get more credit, which the user then uses to buy more things.
Reloading causes a circle of debt that often leads people to take out home equity loans, which give them an amount equal to 125% of the value of their home. This kind of loan usually has bigger fees: The borrower took out more money than the house is worth, so the house isn’t enough to cover the whole loan. Also, you should know that the interest you pay on the part of the loan that is more than the home’s value is never tax deductible.
When you ask for a home equity loan, you might be tempted to take more than you need right now because you only get the money once and you don’t know if you’ll be able to get another loan in the future.
If you’re thinking about taking out a loan that’s worth more than your home, it might be time to wake up. When you only owed 100% of the value of your home, did you not have enough money to live on? If so, it’s probably not realistic to think you’ll be better off if you add 25% to your debt, plus interest and fees. This could make it easier to go bankrupt and lose your home.
Home Equity Loan Requirements
Each company has its own standards, but most people will need the following to get a home equity loan:
- Their home is worth more than 20% of what they have in it.
- History of income that can be checked for at least two years
- A credit score of 600 or more
- Even if you don’t meet these standards, you might still be able to get a home equity loan, but you’ll have to pay a much higher interest rate through a lender who works with high-risk borrowers.
Find a statement from your lender or go to their website to find out how much you owe on your mortgage, second mortgage, HELOC, or home equity loan. You can figure out how much your home is worth by comparing it to recent sales in your area or using a site like Zillow or Redfin to get an estimate.
Be aware that their estimates of your home’s value aren’t always right, so change your own estimate based on how your home looks now. Then, divide the total amount you still owe on all of your loans by what you think your property is worth right now to find out how much equity you have in your home right now.
How does a loan against home equity work?
A home equity loan is a loan for a set amount of money that you pay back over a set amount of time. The loan is secured by the value of your home. If you can’t pay back the loan, you might have to give up your house.
Are home equity loans tax deductible?
If you use the money from a home equity loan to “buy, build, or substantially improve” your house, the interest you pay on the loan may be tax-deductible. But since the Tax Cuts and Jobs Act was passed and the standard deduction was raised, most people may not save money by itemizing to reduce the interest they pay on a home equity loan.
How much money can I borrow against my home?
For well-qualified buyers, the maximum amount they can borrow with a home equity loan is the amount that brings their combined loan-to-value (CLTV) to 90% or less. This means that the total amount owed on the mortgage, any existing HELOCs, any existing home equity loans, and the new home equity loan cannot be more than 90% of the home’s estimated value. For example, if a person’s home is worth $500,000 and they still owe $200,000 on their mortgage, they could get a home equity loan for up to $250,000.
You can get both a HELOC and a home equity loan at the same time.
Yes. You can have both a HELOC and a home equity loan at the same time, as long as you have enough value in your home and enough income and credit to qualify for both.
What’s a HELOC loan?
A HELOC loan doesn’t exist. The term is a mix of a home equity line of credit (HELOC) and a home equity loan, which are two different types of loans.
In conclusion
If you know exactly how much equity you need to take out and want the comfort of a set interest rate, a home equity loan might be a better choice financially than a HELOC. Borrowers should be careful when taking out home equity loans to pay for home fixes or to consolidate debt. If too much property is taken out, it’s easy to go low on a mortgage, which can ruin a borrower’s credit and lead to default.
