Home Equity Loan: What it Is
A home equity loan is collateralized or secured by your home, and may have a term ranging from 5 to 30 years. These loans are often referred to as second mortgages because the lender's position is subordinate to the first lender's. This means that if you default on your mortgage(s), the first lender gets paid, and the second lien holder only gets fully repaid if there is sufficient equity.
Due to the added risk, second mortgages usually carry higher interest rates than first mortgages. However, second mortgages often cost little or nothing to originate. There are two main types of home equity mortgages--fixed home equity loans, and lines of credit (HELOC). Each works differently and is appropriate for different situations.
- Traditional Home Equity Loan: This loan delivers a lump sum at closing, and you repay it with regular monthly installments. Most of these mortgages come with fixed interest rates and payments, but some offer the option of a variable rate, and some allow you to fix a variable rate at one or more times during the life of the loan. These loans are the most appropriate when you need a large sum all at once. For example, debt consolidation, a medical emergency, the down payment on an investment property or vacation home, or a major home renovation
- Home Equity Line of Credit, or HELOC: This product offers flexibility for those who need access to funds over time--to provide emergency cash flow for a new business, fund a home improvement project over time, or pay annual college tuition installments. HELOCs function like credit cards, allowing you to draw on them and repay them over and over. The first years of a HELOC are called the drawing period; during that time you may tap the funds as often as you need and your payment is determined by your loan balance and interest rate (which is usually variable). After a number of years, the drawing period ends, and you make monthly payments to retire the loan by the end of its term. You may have the option of fixing your HELOC interest rate at one or more points during the repayment period, which is helpful for budgeting your payments
Home Equity Loan: Advantages
- Interest paid is usually tax deductible if you file a Schedule A
- Because it is secured by property, the interest rate is usually much lower than that of other consumer debt like credit cards
- Because loan balances are stretched out over longer terms, payments can be more affordable
- Unlike credit card debt, terms cannot be changed once the loan papers have been signed
- HELOCs can be repaid and reused over and over
- HELOCs may offer the convenience of check writing
- Home equity loans are inexpensive to originate
Home Equity Loan: Trade-offs
- Interest over the life of the loan may be more if a balance is stretched over a longer period
- Paying off unsecured debt like credit card balances with a secured loan means that you won't be able to discharge it in a bankruptcy filing
- Inability to make the home equity loan payment could result in foreclosure
- Some home equity loans come with prepayment penalties
Some home equity loans, called purchase-money second mortgages, are used when you buy a home and have less than 20% to put down. Some buyers do this to avoid paying for mortgage insurance, while others do it because a larger down payment results in lower fees for their first mortgage. These "piggy back" loans become much harder to get when the economy is unhealthy.