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Home Equity Loan Basics

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Home Equity Loan BasicsA home equity loan, commonly referred to as a second mortgage, is a note or line of credit that is secured or collateralized by the equity in your home.

The term of a home equity loan is generally shorter than that of a first mortgage, and similar to a first mortgage, the lender has the right to take your home if you default.  A home equity loan can be a valuable borrowing option due to the low interest rates and tax deductibility of the interest.

There are two general types of home equity debt: home equity loans and home equity lines of credit, or HELOCs.  For simplicity, I oftentimes use “home equity loan” in this article to refer to both a home equity loan as well as a HELOC.

Home Equity Loan

A home equity loan gives you a one-time lump sum in exchange for a note with a fixed interest rate that must be paid off over a set term.  Home equity loans are generally used for a single, large purchase or expense, such as an expensive medical procedure or a major home repair or improvement.

HELOC

There also exist home equity lines of credit, or HELOCs, which borrowers may be pre-approved for up to a set limit.  During the specified term, the borrower may borrow against the HELOC on an as needed basis, much like a credit card.

HELOCs generally have a variable interest rate, rather than a fixed interest rate, and the initial interest rate on the line of credit is oftentimes lower than the fixed rate charged on a home equity loan.

HELOCs are commonly used for multiple recurring costs, such as college tuition.

Pros of a Home Equity Loan

  • Interest paid on a home equity loan may be deductible.  Interest paid on most other forms of consumer debt, such as credit card debt, is not normally deductible.
  • The proceeds of a home equity loan may be used for anything, not just home related expenses.
  • Interest rates on secured home equity loans are generally lower than the interest charged on other types of unsecured consumer debt.  You can lower your rate by getting quotes from multiple lenders.  LendingTree is a great site where you can get quotes from multiple lenders in a matter of minutes.
  • For responsible borrowers, it can be a good resource to fall back on if a very large, unexpected expense exceeds their emergency fund

Cons of a Home Equity Loan

  • Too often people seek a quick fix rather than changing bad habits and saving for a large purchase.
  • You will likely be charged fees and closing costs to take out a home equity loan, just like when you took out your first mortgage.  HELOCs may also involve fees and closing costs.
  • If you default on home equity debt, you could lose your home.
  • Home values could drop, leaving you owing more than what the home is worth.
  • HELOCs generally have variable interest rates which are generally riskier to the borrower than fixed rate loans.
  • Home equity loans and HELOCs may charge prepayment penalties, and credit lines may charge other fees as well.
  • Home equity interest rates are generally higher than the rates on primary mortgages.

Home Equity Loans to Pay Off Credit Cards

Many people use home equity loans to pay off their credit cards.  While this does have the advantage of converting high, non-deductible interest to lower, deductible interest, it also converts unsecured debt to secured debt.

If you don’t pay off your credit card debt, your credit will get hammered.  If you don’t pay off your home equity loan, your credit will take a hit and you may lose your home.

Before taking out a home equity loan to pay off credit cards, you might at least consider other options to getting out of debt.

Home Equity Loans to Fund Home Improvements

Many homeowners tap into the equity in their homes to fund major home improvements.  However, keep in mind that some improvements will greatly increase the value of your home while others won’t, even if they cost a lot of money to do.

Home Equity Loan Tips

  • Before taking out a home equity loan, ask yourself if doing so will bring you closer to reaching your financial goals or farther away.
  • Make sure that you can afford to make the payments on any loan you take out and that you understand all the terms of the loan.  If you can’t, you risk losing your home.
  • Ask your financial advisor if the interest on your home equity loan will be tax deductible and if you will receive any tax benefit from it.
  • Check your credit report and FICO scores before taking out a home equity loan.  If your creditneeds to improve in order to receive the best interest rate on the loan, take the appropriate steps.
  • The equity in your home is the difference between the value of the home and how much you still owe on your mortgage.  You likely won’t quality for a home equity loan if you have little or no equity in your home.  Make sure you have enough equity in your home before paying any expenses or fees or you might be wasting your money.
  • In addition to home equity loans, cash-out refinancing is another popular way to tap the equity in one’s home.  Cash-out refinancing involves refinancing the primary mortgage for more than the outstanding loan balance, and receiving the difference in cash.

Additional Home Equity Loan Resources

For additional information on home equity loans, check out the below book:


Have you ever taken out a home equity loan?  What home equity loan tips do you have?  Leave a comment below!

Image: Mark P/Bigstock

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{ 2 comments… add one }

  • Stefanie Gladden January 15, 2013, 6:55 pm

    also liked on facebook – Ann Lyfe
    and shared -https://www.facebook.com/ann.lyfe/posts/327621687342656

    Reply
    • LD January 15, 2013, 7:02 pm

      Thanks Stefanie!

      Reply

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