A home equity loan, often referred to as a second mortgage, allows homeowners to borrow money by leveraging the equity they’ve built in their property. This financial tool gained significant traction in the late 1980s due to its tax deductibility, which somewhat offset the elimination of interest deductions for most consumer purchases by the Tax Reform Act of 1986.
While the Tax Cuts and Jobs Act of 2017 modified this deduction for loans taken out after 2017, interest paid on a home equity loan can still be tax-deductible if the funds are used for qualified home renovations or to “buy, build, or substantially improve” the home, as defined by the IRS. However, interest is no longer deductible if the funds are used for personal purchases or to consolidate credit card debt. Despite these changes, home equity loans remain attractive due to their relatively lower interest rates compared to other types of consumer loans.
How Do Home Equity Loans Work?
Home equity loans come in two primary forms: fixed-rate loans and revolving lines of credit (HELOCs). Both types allow you to borrow against a percentage of your home’s appraised value, minus any outstanding mortgage debt. Typically, you can borrow up to 80% of your home’s value (assuming no first mortgage, or as a combined loan-to-value with your first mortgage).
Crucially, your home serves as collateral for these loans. This means that if you fail to repay the loan or line of credit, the lender has the right to foreclose on your home, taking possession and selling it to recover the outstanding debt.
Fixed-Rate Loans
- Lump Sum Payment: You receive the entire loan amount as a single, upfront payment.
- Fixed Interest Rate: The interest rate is set at the time of closing and remains constant throughout the loan’s lifetime.
- Set Repayment Period: The loan is repaid over a predetermined period, typically ranging from 5 to 15 years, with consistent monthly payments of principal and interest.
Home Equity Lines of Credit (HELOCs)
- Adjustable/Variable Rate: HELOCs function like a revolving credit card, meaning the interest rate can fluctuate based on market conditions, similar to an adjustable-rate mortgage. This causes monthly payments to vary.
- Draw Period: You are approved for a certain spending limit and can withdraw money as needed during a draw period, usually lasting 5 to 10 years. During this period, you often make interest-only payments.
- Repayment Period: After the draw period ends, draws are no longer allowed, and a repayment period begins, typically lasting 10 to 20 years. During this phase, you must repay both principal and interest. Some lenders may offer the option to convert to a fixed rate during the repayment period.
Common Uses for Home Equity Loans:
Popular uses include paying off high-interest credit card debt, funding home improvements, and covering college expenses.
Benefits for Consumers and Lenders
Benefits for Consumers:
- Accessible Cash: Home equity loans provide an easily accessible source of funds.
- Lower Interest Rates: Although typically higher than a first mortgage, home equity loan rates are significantly lower than those for credit cards and other unsecured consumer loans.
- Debt Consolidation: Many consumers use fixed-rate home equity loans to consolidate high-interest credit card debt, resulting in a single, lower-interest payment. However, remember that interest on funds used for debt consolidation is not tax-deductible.
Benefits for Lenders:
- Interest Income and Fees: Lenders earn interest income and fees on both the initial mortgage and the subsequent home equity loan or second mortgage.
- Collateral Security: The home serves as collateral, reducing the lender’s risk. In case of default, the lender can repossess and sell the property to recover the loan proceeds through foreclosure.
- Default Avoidance: While foreclosure is an option, lenders generally prefer to work with borrowers to establish a payment arrangement to avoid it, as their primary business is lending money, not managing real estate.
Warning: The main risk of a home equity loan is the potential loss of your home if you default on payments.
The Right Way to Use a Home Equity Loan
Home equity loans are valuable tools for responsible borrowers with a stable income who can confidently repay the loan. Their low interest rates make them a sensible option for:
- Fixed-Rate Loans: Ideal for covering the cost of a single, large purchase, such as a new roof or an unexpected medical bill.
- HELOCs: Convenient for managing short-term, recurring costs, like quarterly college tuition payments.
Recognizing the Pitfalls
- Reloading: A significant pitfall is the cycle of “reloading,” where borrowers use home equity loans to pay off existing debt and free up credit, only to accumulate more debt. This can lead to a dangerous spiraling debt cycle. Be particularly wary of loans for 125% of your home’s equity, as these come with higher fees and are unsecured for the portion exceeding your home’s value, increasing the risk of bankruptcy.
- Home Improvements: While some home improvements, like kitchen or bathroom remodels, add significant value, others, such as a swimming pool, may be valued more by the homeowner than by the market. Ensure that the improvements you finance will add enough value to cover their costs.
- Paying for College: While a popular reason, older borrowers nearing retirement should carefully consider how a home equity loan for college expenses might impact their retirement goals and explore other options.
- Loan Due Upon Sale: Both fixed-rate home equity loans and HELOCs must be repaid in full if the home securing them is sold.
Tax Deductibility of Home Equity Loan Interest
You can deduct the interest paid on a home equity loan if, according to the IRS, the funds are used to “buy, build, or substantially improve” the home that secures the loan. If the funds are used for personal purchases or to consolidate credit card debt, the interest is not tax-deductible. This provision is in effect from 2018 and ends after 2025.
What Is the Downside of a Home Equity Loan?
The primary downside is that your home is used as collateral. While interest rates are generally lower than unsecured loans, they are typically higher than a first mortgage. If you default on payments, the lender can foreclose and take possession of your home. Therefore, it is critical not to borrow more than you can comfortably repay.
What’s the Difference Between a Home Equity Loan and a Home Equity Line of Credit (HELOC)?
| Feature | Home Equity Loan | Home Equity Line of Credit (HELOC) |
| Funding | Single, lump-sum payment received upfront. | Revolving line of credit; draw funds as needed up to a limit. |
| Interest Rate | Fixed interest rate; payments remain constant. | Variable interest rate; payments can fluctuate. |
| Repayment | Fixed monthly payments of principal and interest over the life of the loan. | Draw period (e.g., 5-10 years) with interest-only payments, followed by a repayment period (e.g., 10-20 years) with principal and interest. |
The Bottom Line: Could a Home Equity Loan Be Right for You?
Home equity loans offer a valuable way to access the cash tied up in your home’s equity for various purposes like home repairs, debt consolidation, or education expenses. If you have built significant equity, maintain a strong credit score, and have a low DTI ratio, a home equity loan can be a beneficial option. The fixed interest rates provide predictable monthly payments, making budgeting easier.
However, the critical consideration is that your home serves as collateral. You must avoid borrowing more than you can comfortably repay to prevent the risk of default and potential foreclosure. If managing two mortgage payments is a concern, a cash-out refinance might be a better alternative, consolidating your debt into a single payment, often at a lower interest rate on the entire loan.
Before borrowing against your home, carefully review your financial situation to avoid the pitfalls of “reloading.” Additionally, thoroughly understand the draw period and repayment terms for any home equity product.