What Is a Home Equity Loan?
A home equity loan—also known as an equity loan, home equity installment loan, or second mortgage—is a type of consumer debt. Home equity 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 homeowner’s mortgage balance due. Home equity loans tend to be fixed-rate, while the typical alternative, home equity lines of credit (HELOCs), generally have variable rates.
- A home equity loan, also known as a home equity installment loan or a second mortgage, is a type of consumer debt.
- Home equity loans allow homeowners to borrow against the equity in their residence.
- Home equity loan amounts are based on the difference between a home’s current market value and the 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 one lump sum, whereas HELOCs offer borrowers revolving lines of credit.
How a Home Equity Loan Works
Essentially, a home equity loan is akin to a mortgage, hence the name second mortgage. The 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 and the rate of interest charged also depend on the borrower’s credit score and payment history.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
Traditional home equity loans have a set repayment term, just like conventional mortgages. The borrower makes 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 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. However, always remember that 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 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 credit card debt, resist the temptation to run up those credit card bills again. Before doing something that puts your house in jeopardy, weigh all of your options.
Home equity loans exploded in popularity after the Tax Reform Act of 1986 because 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 HELOCs 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, for example, is not tax deductible.
Before you take a home equity loan, be sure to compare terms and interest rates. When looking, consider a loan with your local credit union instead of focusing only on large banks, recommends Clair Jones, a real estate and relocation expert who writes for Movearoo.com and iMOVE.com. “Credit unions sometimes offer better interest rates and more personalized account service if you’re willing to deal with a slower application processing time," Jones says.
As with a mortgage, you can ask for a good faith estimate, but before you do, make your own honest estimate of your finances. “You should have a good sense of where your credit and home value are before applying, in order to save money," says Casey Fleming, mortgage advisor at C2 Financial Corporation and author of The Loan Guide: How to Get the Best Possible Mortgage. "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.
The interest on a home equity loan is only tax deductible if the loan is used to buy, build, or substantially improve the home that secures the loan.
Home Equity Loans vs. HELOCs
Home equity loans provide a single lump-sum payment to the borrower, which is repaid over a set period of time (generally five 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 (five 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 offer HELOC fixed-rate options.
Advantages and Disadvantages of a Home Equity Loan
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, low-interest rates and possible tax deductions make home equity loans 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 for what. 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 because the funds are received in one lump sum,” says Richard Airey, a loan officer with First Financial Mortgage in Portland, Maine.
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 that 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 because 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.
Example of a Home Equity Loan
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 your car. Defaulting could result in its loss, and losing your home would be significantly more catastrophic than surrendering a car.
Easy to obtain
Lower interest rates than other debt
Possible tax deduction for interest paid
Easy to obtain
Possible spiraling debt—hence why "easy to obtain" is also a con
Can lead to home foreclosure
Home Equity Loan Requirements
Each lender has its own requirements, but to get approved for a home equity loan, most borrowers will generally need:
- Equity in their home > 20% of their home's value
- Verifiable income history for two or more years
- A credit score > 600
Though it is possible to get approved for a home equity loan without meeting these requirements, expect to pay a much higher interest rate through a lender that specializes in high-risk borrowers.
How to Calculate Home Equity
Determine the current balance of your mortgage and any existing second mortgages, HELOCs, or home equity loans by finding a statement or logging on to your lender's website. Estimate your home's current value by comparing it to recent sales in your area or using an estimate from a site like Zillow or Redfin. Be aware that their value estimates are not always accurate so adjust your estimate as needed considering the current condition of your home. Then divide the current balance of all loans on your property by your current property value estimate to get your current equity percentage in your home.
|Average Home Equity Interest Rates|
|Loan Type||Average Rate||Range|
Rates assume a loan amount of $25,000 and a loan-to-value ratio of 80%. HELOC rates assume the interest rate during initiation of the credit line, after which rates can change based on market conditions.
The Bottom Line
A home equity loan can be a better choice financially than a HELOC for those who know exactly how much equity they need to pull out and want the security of a fixed interest rate. Borrowers should take out home equity loans with caution when consolidating debt or financing home repairs. It is easy to end up underwater on a mortgage if too much equity is pulled out, leaving a borrower with ruined credit and a home in foreclosure.