If you’ve ever heard someone mention taking out a “second mortgage,” they’re referring to a home equity loan. This type of loan allows homeowners to borrow money by leveraging the equity in their home, which is the portion of the mortgage they’ve already paid off.
Home equity loans became popular in the mid-1980s as a way for homeowners to offset the impact of the Tax Reform Act of 1986, which eliminated the deduction for consumer loan interest. With a home equity loan, homeowners could borrow up to $100,000 of their home’s value and deduct the interest paid on the loan. However, tax laws have since changed, and homeowners can now only receive tax deductions on home equity loan interest if the loan is used for significant home improvements or renovations.
What Home Equity Loan Is Right for You?
There are two main types of home equity loans, typically designed to be paid off within 5-15 years:
- Fixed-Rate Loans: The borrower receives a lump sum upfront and repays it over time at a set interest rate. The loan’s terms, such as the monthly payments and interest, are locked in when the loan is issued.
- Home Equity Line of Credit (HELOC): This loan works like a credit card, which is why it’s called a “variable-rate loan.” Borrowers are given a spending limit they can draw from as needed. Some even receive a credit card to access the funds. Because it’s a variable-rate loan, payments and interest rates fluctuate based on how much is borrowed and the current interest rate. With this type of loan, it’s important to have a steady income to keep up with payments, as your home equity serves as collateral.
Equity Pros and Cons
Like any loan or line of credit, home equity loans have their pros and cons. To avoid surprises, it’s crucial to read the fine print. When discussing your loan options with a lender, ask about interest rates, whether they’re fixed, how payments work, and any other relevant details.
Remember, with a home equity loan, you’re borrowing against your home’s equity. For example, if your home is worth $200,000 and you owe $80,000, your equity is $120,000. It’s important to understand that your home is used as collateral, meaning if you default on the loan, the bank could foreclose on your home. Interest rates for home equity loans are typically higher than those for fixed-rate mortgages and other consolidation loans. Additionally, you’ll need to account for closing costs and fees, which are common with many types of loans.
Benefits for All
So why consider a home equity loan? Many homeowners appreciate these loans because they provide access to funds for necessary home improvements or financial relief during tough times. As you repay the outstanding balance, the available credit is replenished. Home equity loans generally offer lower interest rates than personal loans and credit cards. With a fixed-rate loan, you can lock in your interest rate and know exactly what your monthly payments will be.
Your Home Equity Loan
Whether you’re planning major home renovations—such as making your home wheelchair accessible or adding a new room for a family member—or need to consolidate debt, a home equity loan can provide the cash you need. It’s a flexible way to finance large expenses while potentially securing a lower interest rate.