What is a home equity loan and how does it work?
A home equity loan is a type of loan that uses your home as collateral to secure the debt. It is one of two types of home equity-related financing methods, the other being home equity lines of credit (HELOCs).
Home equity loans are similar to personal loans in that the lender issues you a lump-sum payment and you repay the loan in fixed monthly installments. A HELOC operates similar to a credit card in that you borrow money on an as-needed basis. HELOCs come with draw periods that normally last 10 years. During this period, you can use money from the credit line, and you’re only responsible for making interest payments.
Both options require you to have a certain amount of home equity; this is the portion of the home you actually own. Lenders typically require that you have between 15 percent and 20 percent equity in your home in order to take out a home equity loan or line of credit.
One drawback is that home equity loans and lines of credit have closing costs and fees similar to a standard mortgage. Closing costs vary, but can run into the thousands of dollars based on the value of a property.
What are the pros and cons of a home equity loan?
Like any financing tool, home equity loans come with pluses and minus.
Pros of home equity loans
Lower interest rates: Because they are secured loans (backed by collateral — your house in this case), the interest charged on a home equity loan is much lower than that on unsecured debt. It’s more akin to mortgage rates’ and, while those have been rising lately, they’re still much lower than the double-digit rates on many personal loans or credit cards.
Longer terms: Home equity loans often have 15-, 20- or 30-year terms—much longer to repay than many personal loans.
More funds: Since the amount you can borrow is based on your equity stake in your home — probably your single biggest asset—you might qualify for larger sums than you could with a personal loan.
Tax advantages: You might be able to deduct the annual interest you pay on your home equity loan, just as you can on your primary mortgage. If you use the home equity loan to upgrade, buy or repair your home, the interest on it is often tax-deductible (up to a certain amount of debt). You must itemize deductions on your tax return.
Cons of home equity loans
Long application: A home equity loan is essentially a second mortgage — and applying for one means going through a similar process: much paperwork to collect and file, a home appraisal to schedule, closing costs to pay. It’s somewhat less lengthy and expensive than the first time ‘round, but even so, it can take a month at least. Not the loan for emergencies or if you need funds fast, in other words.
Hocking the house: Your home acts as the collateral for your home equity loan. Fail to make payments and your lender could foreclose on it. Also, if real estate prices drop substantially, the sum total of your home-backed debts (mortgage and home equity loan) could become greater than your home’s value putting it underwater (aka negative equity, meaning you owe more than the home is worth).
Diluted ownership stake: By borrowing against your home equity, you’re essentially lowering the amount of the home you own outright — swapping part of your stake for ready cash, in other words. The loan will cut into your proceeds if and when you sell the home, as you’ll have to repay it in full (as you would your mortgage) when you surrender title.
How to calculate home equity
You can calculate your ownership stake on your own. You’ll need two numbers: the fair market value of your home, and the amount left to repay on your mortgage.
Assume your home’s current value is $410,000, and you have a $220,000 balance remaining on your mortgage. Subtract the $220,000 outstanding balance from the $410,000 value. Your calculation would look like this:
$410,000 – $220,000 = $190,000
In this case, your home equity would be $190,000 — a 46% stake.
How to build home equity
Building home equity is the first step to obtaining a home equity loan. It’s a lot easier to build equity if you made a larger down payment on the home initially, because you already have a sizable stake in the property.
Another way to build equity is to increase your home’s value by renovating it. (Keep in mind certain home improvement projects have a stronger return on investment than others.) In addition, you can build equity faster by making extra payments towards your mortgage principal, such as biweekly payments or one additional payment a year.
Basic uses for home equity loans
Debt consolidation and home improvements are the most common reasons homeowners borrow from their equity, says Greg McBride, CFA, chief financial analyst for Bankrate. There are other reasons borrowers might tap home equity, as well, such as education costs, vacations or other big-ticket purchases.
Borrowers can deduct the interest paid on HELOCs and home equity loans if they use the funds to buy, build or improve the home that serves as collateral for the loan.
Using a home equity loan can be a good choice if you can afford to pay it back. However, if you can’t afford to repay the loan, you risk the lender foreclosing on your home. This can ruin your credit, making it hard to qualify for other loans in the future.
Are home equity loans tax-deductible?
Home equity loans themselves are not tax-deductible, but In certain circ*mstances, the interest you pay on them is.
The interest you pay annually on the loan can be deducted from your federal income tax if you use the home equity loan to buy, build or substantially improve the home that secures it. Joint filers who took out a home equity loan can deduct interest on up to $750,000 worth of qualified loans and single filers can deduct interest on up to $375,000. To take advantage of this tax break, you'll need to itemize your deductions at tax time.
HELOCs vs. home equity loans
Home equity loans give you a lump sum upfront, and you’ll repay the loan in fixed installments. The loan term can vary from five years to 30 years. Having a fixed amount could make impulse spending less likely, and make it easier to budget for your monthly payments. However, you can’t take out a higher amount to cover an emergency unless you obtain an additional loan, and you would have to refinance to take advantage of a lower interest rate.
In contrast, a HELOC is a revolving line of credit that taps your home equity up to a preset limit. HELOC payments aren’t fixed, and the interest rate is variable. You can draw as much as you need, up to the limit, during the draw period, which can last as long as 10 years. You’ll still make payments during the draw period, which are typically interest-only. After this period, you’ll repay both interest and principal over the loan’s remaining term.
Both HELOCs and home equity loans involve putting your home on the line as collateral, so they tend to offer better interest rates than unsecured debt such as a personal loan or credit card.
How to apply for a home equity loan
To apply for a home equity loan, start by checking your credit score, calculating the amount of equity you have in your home and reviewing your finances.
Next, research home equity rates, minimum requirements and fees from multiple lenders to determine whether you can afford a loan. While doing so, make sure the lender offers the type of home equity product you need — some only offer home equity loans or HELOCs rather than both.
When you apply, the lender will ask for personal information such as your name, date of birth and Social Security number. You’ll also be asked to submit documentation, which may include tax returns, pay stubs and proof of homeowners insurance.
