The basics of home equity loans
If you have equity in your home and need cash, one option you have is to obtain a home equity loan.
This type of loan allows you to borrow money using your home’s equity, which is the difference between its value and what you still owe on it, as collateral. If you have a home appraised at $250,000, and you still owe $125,000 on the original mortgage, you have $125,000 in equity, a portion of which you can borrow against.
Home equity loans are often used to pay off debts with high-interest rates, such as credit card debt or personal loans. Home equity loans typically offer lower interest rates than unsecured debt. People also use home equity loans to consolidate and pay off multiple debts, which lowers the monthly payment.
Some also use home equity loans to finance a home improvement project or other large expense, such as funding a child’s college education.
Most lenders will allow you to borrow up to 80 percent of the equity in your home. So if you have $100,000 in equity, you can borrow up to $80,000. Some lenders will allow borrowers to exceed that percentage for a higher interest rate. In addition to having home equity, lenders will also assess your credit worthiness and your current debt-to-income in determining whether to make the loan.
Home equity loans are an alternative to home equity lines of credit (HELOCs). A HELOC allows you to borrow a little at a time against an established line of credit based on your home’s equity. The borrower also does not begin repaying loaned funds from a HELOC for several years. The interest rate on loaned funds, therefore, may fluctuate over the life of the loan.
With a home equity loan, you are borrowing the full amount of the loan at once. Plus you begin making monthly payments right away, and the rate you pay is usually fixed.
One of the advantages of using a home equity loan is that, like a standard mortgage, the interest is tax deductible. If you use the loaned funds on a home improvement project or major repair, you can usually deduct the full amount of interest paid on the second mortgage. If you use the funds for other reasons, you can only deduct the interest on the first $100,000 you borrow, or $50,000 if you are a single filer.
Other advantages include:
The interest rate on a home equity loan is typically lower than other types of consumer debt.
You can use the funds any way you like.
Because lenders are most concerned with how much equity is in your home, you can often get a loan with less-than-stellar credit, although you’ll pay a higher interest rate than a borrower with good credit.
You can take as much as 15 years to even 30 years to repay the debt.
Like your primary mortgage, a home equity loan is secured by your home. That means if you default, the lender can foreclose on your house. Even if you keep up your payments on the primary mortgage, defaulting on the home equity loan can lead to foreclosure; in this case, the lender for the second mortgage will sell the house and repay the lender of the first mortgage, then keep the remaining proceeds for itself.
Homeowners should also be careful about taking out a home equity loan if there’s a chance they’ll be moving in a few years. Reducing the home’s equity means you’ll have less money available to pay the costs of selling the home, such as the real estate agent’s commission. Plus you will have less money to allocate to a downpayment on your next home.