What is a Home Equity Loan

What is a Home Equity Loan - LoansPedia

A home equity loan, also known as a home equity line of credit, or heloc, has quickly become one of the most important loans to the modern borrower. Not only do home equity loans allow you to easily extract home equity from your current home, but they also afford several tax benefits that other sources of credit do not.

A home equity loan or line of credit is a loan that is written against the equity that you own in your home. Equity, in terms of real estate, is the amount of your home that is left over after you subtract all debts from the market value. If, for example, you own a home worth $200,000 and have $120,000 remaining on your mortgage, then you have home equity of $80,000, or the difference between $200,000 and $120,000.

As recently as 2005, home equity loans became a very popular source of personal credit for Americans. Not only were real estate prices rising, which instantly afforded homeowners more home equity from which they could borrow, but the cost of borrowing (interest rates) started to fall. Combine falling costs with growing supplies of available credit and it’s easy to see why home equity loans became a popular funding source.

There are other reasons home equity loans are so popular:

Tax implications – Home ownership in the United States is highly subsidized. In order to improve the home ownership rate, American politicians have offered to homeowners the ability to write-off on their taxes the total mortgage interest they pay. Thus, if a family pays $10,000 in home mortgage interest in one year, then they do not pay taxes on $10,000 of their income, as it is exempted by the IRS. Home equity loans are just like your first mortgage; any interest that is paid on a home equity loan can be deducted against your income. So, if you are in a 25% tax bracket and can file a 1040 to write off your mortgage interest, your interest rate on the loan is effectively 25% lower. A 6% interest rate would be effectively reduced to 4.5%, while a 9% rate would become a 6.75% interest rate.

Ease of access – Assuming that you have enough positive equity in your home to borrow sufficiently, home equity loans are extremely easy to access. In most cases, a bank will give home equity loans on a loan-to-value basis, or LTV. This loan to value is usually offered up to 90%–a homeowner with a $150,000 home, and with $80,000 in mortgage debt would be able to borrow as much as $55,000. To calculate that amount, a banker would allow for an LTV of up to 90% of $150,000, or $135,000, before subtracting debts of $80,000 to arrive at a possible maximum loan of $55,000.

Low rates – Compared to most other financing sources, home equity loans are very inexpensive, often only slightly more than a regular mortgage rate. A home equity loan requires that you put very little, if anything, down to borrow the money, and it will often stipulate that you need to have only sufficient income and home equity in order to qualify.

Easy refinancing – Home equity loans make refinancing your current mortgage very easy, especially if you have made a significant dent in your total purchase price. If you have an existing mortgage, and would like a newer, lower rate, consider opting for a home equity loan or home equity line of credit for a very simple, straightforward refinancing loan.

Default – Just like any mortgage or second mortgage, a home equity loan is a loan that is taken against the value of your house. Thus, if you do not make routine payments, your home will be taken as collateral in foreclosure. This is not the case with higher-interest credit cards and personal lines of credit, however, the lender assumes far less risk in making a home equity loan since they know that they own the home if you fail to pay. The benefit for you is a lower interest rate than unsecured debt.

Rising rates – If you do decide to take out home equity via a home equity loan or line of credit, always carefully read the terms. While home equity loans are generally paid-for over the course of many years at a fixed rate of interest, lines of credit are often issued with variable rates of interest. Variable interest rate lines of credit can be more costly if interest rates rise, and you should be prepared to make higher monthly payments if rates rise.