What is a Home Equity Loan?
A home equity loan is a loan that can be taken out using a house as collateral to guarantee the loan will be repaid. It is also known as a second mortgage.
Assume a house is worth 400,000 USD and the homeowner still owes 250,000. In this case the homeowner has 150,000 USD as equity.
The homeowner can use this equity (150,000 USD) to get a loan. The interest on this type of loan will be higher than the first mortgage, but lower than borrowing on a credit card.
People typically take out home equity loans in order to pay for major expenses such as existing debts, improving or extending their home, medical bills, a new car, or private school/college education.
There are two types of home equity loans: home equity loans and home equity lines of credit (HELOCs).
A home equity loan gives homeowners funds for a one-time expense at a fixed interest rate with a definite payoff date.
In the United States, you can borrow up to $100,000 and deduct all of the interest when you file your tax returns.
Home equity line of credit (HELOC)
This is an adjustable rate mortgage with a rate established by an index (the prime rate) and a margin (which is determined at the time the loan is created). The margin is the difference between the prime rate (what banks charge their most creditworthy customers for loans) and the interest rate that will be paid.
In comparison to a normal loan, a HELOC does not charge interest if you don’t draw out of a pool of available money. What makes a HELOC appealing is that it gives people access to money and they only pay interest on what they use.
Why would people want to take out a home equity loan or HELOC?
- – To consolidate credit card debt.
- – They tend to have low interest rates versus credit cards.
- – Interest may be tax deductible.
- – A degree of payment stability – with fixed interest rates.
- – To pay off a mortgage quickly.
Are there any risks?
As opposed to credit card debt, if you fail to meet your home equity loan payments your home is at risk of being repossessed by the lender. In addition, home equity loans are typically long term loans and you may end up paying a lot of interest – depending on how you use the loan or line of credit.
ft.com/lexicon defines a home equity loan as:
“An additional loan that a borrower takes out on a particular property, as a way to obtain money.”
Video explanation – A home equity loan