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What is a Home Equity Loan?

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  • Written By: Damir Wallener
  • Edited By: Lindsay D.
  • Last Modified Date: 08 November 2018
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    Conjecture Corporation
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A home equity loan allows homeowners to access the equity in their primary residence without having to sell the property. Equity is the difference between what a home is worth and what is owed against it. Traditionally, home equity loans were called second and third mortgages.

Equity in a home comes from two sources. Mortgage payments, over a period of time, reduce the amount owed against a property, and real estate appreciation increases the gross value. After several years of making mortgage payments, the equity accrued can be substantial. For example, a home purchased for $250,000 with a zero down payment mortgage and appreciating 5% a year may have $50,000 in equity in as little as five years.

Banks and finance companies often give favorable rates on home equity loans as real estate is perceived to be a very stable investment. This is especially true when the economy isn't struggling, as real estate has a long history of appreciation. Mortgage lenders also have access to quasi-governmental agencies such as the Federal National Mortgage Agency (Fannie Mae) that reduce lending rates by shifting interest risk away from the lender.

While home equity loans have favorable rates relative to auto loans or credit card debt, the rates are still higher than for a first mortgage. A home equity loan can be turned into a first mortgage through a process known as refinancing.

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A reverse mortgage is similar to a home equity loan in that it allows access to the cash value of the homeowner's equity. Instead of a lump sum, however, a reverse mortgage pays out in monthly or quarterly payments. Reverse mortgages are targeted at seniors who would like additional income, but don't wish to sell their homes and move. Upon death, the home is either sold by the estate or the title reverts to the lender, who then sells the property themselves.

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cupcake15
Post 5

@BrickBack - That is true. I also know that you can deduct your home equity loan interest because the mortgage is on your primary home. The only time that I think that it is a mistake to take out a home equity loan is when you are trying to consolidate credit card or other unsecured debt.

I heard a famous financial advisor say that that is a really bad idea because unsecured debt like a credit card does not have the same implications that secured debt like a home equity loan or line does. For example, if you default on your credit cards, a credit card company may sue you, but they can’t force you to sell your home in

order to satisfy that debt.

However, if you default on your home equity loan you can lose your house because this is a recourse loan and the banks can force you to either pay them what you owe or sell your house to get what is owed to them.

With credit card debt you can’t lose your house, but with a home equity loan or line you absolutely can. This is why banks love these kinds of loans because they less risky for them.

BrickBack
Post 4

@Oasis11 - I have heard of people doing that because a lot of condo buildings were blacklisted by banks. I know that home equity loans are a little different than the home equity lines because the home equity loan is usually a fixed rate loan that has an exact payoff date, while the home equity line is usually a variable rate and like a credit card you only start paying on it when you start withdrawing from it.

Also, I know that a home equity line is renewable. For example, my home equity line is good for ten years, but if at the end of the ten years I still have a balance on my home equity line then I

can refinance it for another ten years.

The fixed home equity loan offers much higher interest rates than the home equity line of credit. For example, the home equity loan at my bank at the time that I obtained my line was 8.5%, while my home equity line of credit was .25% above prime or 3.25%. While this is a variable rate, I rather take my chances with my low rate because it would take a while for my 3.25% to reach 8.5%.

Also, I plan on paying off my loan as quickly as possible so I am not too concerned with the rates going up.

oasis11
Post 3

@SurfNTurf - I agree with you and the payments are usually interest only so they are very small in comparison to a regular mortgage. I remember a few years back I got an home equity mortgage loan in order to finance another property.

It was a resort property that had less than 50% owner occupants and had a 25% foreclosure rate. The bank did approve me for a regular mortgage loan, but would not finance this property because of its low owner to renter ratio as well as its high foreclosure rate.

They did however, allow me to obtain a home equity line of credit on my primary residence that was paid off. I used these funds to finance my purchase for my beachfront condo and had no costs at closing because this was a bank owned property and it was considered a cash purchase.

surfNturf
Post 2

@Obsessedwithloopy - I agree that taking on too much debt is not a good idea especially in these difficult economic times, but I do think that taking out a home equity line is not a bad idea.

A home equity line is a revolving line of credit that works like a credit card. The bank approves you for a certain amount based on the equity in your home and your credit rating.

Once you are approved you can begin withdrawing immediately or leave the line open until you need it. Like a credit card, when you use the line you will begin paying back the amount that you borrowed.

I think that if you have sufficient equity in

your home you should considering opening up a credit line because if you ever lose your job you will have another area that you can tap funds from once your savings run out. If you try to apply for an equity line after you lose your job it will be too late because the bank will not approve you.

It can really be used as another safety net in case of an emergency.

obsessedwithloopy
Post 1

Very often we find ourselves strapped for cash and home equity loan is a good way to get money without additional expenses of refinancing or borrowing money at a high interest rate.

Additionally the benefit of the home equity loan is that the interest on the loan might be tax deductible.

However, in general, it is good to have the primary residence paid of as quickly as possible, and not have it used as one would a bank account for money withdrawal.

If times get difficult, such as prolonged illness, or loss of a job, at least the mortgage is either paid off, or monthly payments are low and manageable. It is not good to have mortgage worries on top of everything else, or possibly even loose the home.

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