What is a Home Equity Loan?

Home Equity Loans

A home equity loan or line of credit allows you to borrow money, using your home's equity as collateral.

We will explain what home equity is, what collateral is, how these loans and lines of credit work, why people use them, and what pitfalls to avoid.The most common type of home equity loan is the term loan.

This loan is set for a fixed amount of time, anywhere from five to fifteen years. Such loans are typically granted for up to 80% of the value of the home, but some lenders will lend up to 125% of the home’s value.Is this type of loan right for you?

First, some definitions:

Collateral is property that you pledge as a guarantee that you will repay a debt. If you don't repay the debt, the lender can take your collateral and sell it to get its money back. With a home equity loan or line of credit, you pledge your home as collateral. You can lose the home and be forced to move out if you don't repay the debt.

Equity is the difference between how much the home is worth and how much you owe on the mortgage (or mortgages, if you have more than one on the property).

Example: Let's say you buy a house for $200,000. You make a down payment of $20,000 and borrow $180,000. The day you buy the house, your equity is the same as the down payment -- $20,000: $200,000 (home's purchase price) - $180,000 (amount owed) = $20,000 (equity). Fast-forward five years. You have been making your monthly payments faithfully, and have paid down $13,000 of the mortgage debt, so you owe $167,000. During the same time, the value of the house has increased. Now it is worth $300,000. Your equity is $133,000: $300,000 (home's current appraised value) - $167,000 (amount owed) = $133,000 (equity)

House purchase price: $200,000 Amount borrowed: -$180,000 Down payment/equity: $20,000 Five years later Amount borrowed: $180,000 Principal paid: -$13,000 Amount owed: $167,000 House's appraised value: $300,000 Amount owed: -$167,000 Equity $133,000

A home equity loan (or line of credit) is a second mortgage that lets you turn equity into cash, allowing you to spend it on home improvements, debt consolidation, college education or other expenses.

Equity loans, lines of credit defined ...
There are two types of home equity debt: home equity loans and home equity lines of credit, also known as HELOCs. Both are sometimes referred to as second mortgages, because they are secured by your property, just like the original, or primary, mortgage.

Home equity loans and lines of credit usually are repaid in a shorter period than first mortgages. Most commonly, mortgages are set up to be repaid over 30 years. Equity loans and lines of credit often have a repayment period of 15 years, although it might be as short as five and as long as 30 years.

An increasingly popular alternative to the home equity loan is a line of credit.

This type of loan works like a credit card, and has a revolving line of credit, in which the borrower may borrow against the principal more than once over the life of the loan. The borrower is usually given special checks that he or she may use to write checks against the loan amount. The borrower may borrow a little at a time, or borrow all of the loan amount at once. Unlike the term loan, the interest rate on lines of credit tends to be variable.

This type of loan works best for recurring expenses – a complicated remodeling project accomplished in several stages, or a recurring educational expense such as annual tuition. Each type of loan has its advantages and disadvantages; you simply need to decide if you want a fixed interest rate and fixed payments, or more flexibility in terms of when and how you pay.

Your needs will determine which type of loan is best for you. Either way, under current Federal law, the interest on a second mortgage is deductible from your income taxes up to $100,000.