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.
Key Takeaways
- 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 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 one lump sum, whereas HELOCs offer borrowers revolving lines of credit.
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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 that a homeowner is allowed to borrow will be based partially 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.
Warning
Mortgage lending discrimination is illegal. If you think that you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the United States Department of Housing and Urban Development (HUD).
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.
Advantages
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, then 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 CLTV.
The interest rate on a home equity loan—although higher than that of a first mortgage—is much lower than that of credit cards and other consumer loans. That helps explain why a primary reason that 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, senior loan officer with CrossCountry Mortgage LLC in Portland, Maine.
Disadvantages
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 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 the borrower has taken out more money than the house is worth, the loan is not fully secured by collateral. Also, know that the interest paid on the portion of the loan that is above the value of the home is never tax deductible.3
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 don’t know if you’ll qualify for another loan in the future.
If you are contemplating a loan 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, then it likely will be unrealistic to expect to be better off when you increase your debt by 25%, plus interest and fees. This could become a slippery slope to bankruptcy and foreclosure.
