A home-equity loan, also known as an "equity loan," a home-equity installment loan, or a second mortgage, is a type of consumer debt. It allows home owners to borrow against their equity in the residence. The loan is based on the difference between the homeowner's equity and the home's current market value. Essentially, it is a mortgage, and it also provides collateral for an asset-backed security issued by the lender and tax deductible interest payments for the borrower. As with any mortgage, if the loan is not paid off, the home could be sold to satisfy the remaining debt.
Home-equity loans exploded in popularity after the Tax Reform Act Of 1986, as they provided a way for consumers to somewhat circumvent one of its main provisions, which eliminated deductions for the interest on most consumer purchases. The big exception: interest in the service of residence-based debt. Today, with a home-equity loan, homeowners can borrow up to $100,000 and still deduct all of the interest when they file their tax returns (assuming they make itemized deductions).
Home-equity loans come in two varieties – fixed-rate loans and lines of credit. Fixed-rate 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. They must be repaid in full if the home on which they are based is sold.
How much a person can borrow is partially based on a combined loan-to-value (CLTV) ratio of 80% to 90% of the home’s appraised value. The amount of the loan, as well as the rate of interest charged, will of course also depend on the borrower’s credit score and payment history.
Home-equity loans provide an easy source of cash. Obtaining one 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 credit worthiness 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. As such, the number one reason consumers borrow against the value of their homes via a fixed-rate home-equity loan is to pay off credit card balances (according to bankrate.com). Interest paid on a home-equity loan is also tax deductible, as noted earlier, so by consolidating debt with the home-equity loan, consumers get a single payment, a lower interest rate and tax benefits.
Home-equity loans are a dream come true for a lender, who, after earning interest and fees on the borrower's initial mortgage, earns even more interest and fees. If the borrower defaults, the lender gets to keep all the money earned on the initial mortgage and all the money earned on the home-equity loan; plus the lender gets to repossess the property and sell it again. Even if it didn't finance the first mortgage, the lender is making a secured loan, which can be more advantageous than the typical unsecured or personal loan. From a business-model perspective, it's tough to think of a more attractive arrangement.
Home-equity loans 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, its low interest rate and tax deductibility makes it sensible alternative.
They're generally a good choice if you know exactly how much you need to borrow and what you’ll use the money for. 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 since the funds are received in one lump sum,” says Richard Airey, a loan officer with Finance of America Mortgage in Portland, Maine. Of course, when applying, there can be some temptation to borrow more than you immediately need, since you only get the payout once, and you don’t know if you’ll qualify for another loan in the future.