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Home Equity Loans: The Basics

Home equity loans are very popular. But just what is a home equity loan?

In a nutshell, a home equity loan allows a homeowner to borrow money based on the home's equity.

Equity is the difference between the mortgage balance and the current value of the home. Here's an example: If your house is worth $200,000 right now (regardless of what it was worth when you bought it), and your mortgage balance is $150,000, your equity is the difference -- $50,000.

A home equity loan is based on that equity amount. Banks and other lending institutions will issue a loan for all or part of the equity. The homeowner pledges the property as collateral, and the lender puts a lien against your home. This means that, if you don't make your equity loan payments and repay the amount you borrowed, the lender can take your collateral (your home) and sell it to get its money back (just like with your regular, primary mortgage).

Home equity loans are normally repaid over a shorter period of time than first mortgages. A typical first mortgage will be repaid over 30 years. A home equity loan is usually repaid over 15 years (but this can vary).

Benefits of Home Equity Loans

A home equity loan basically lets you turn your home's equity into cash. You can use that cash to make home improvements, pay off credit card or other debts, fund your child's college education -- or anything else.

The interest rates for home equity loans are typically much lower than those of other types of loans or credit cards.

The major benefit of a home equity loan is that the interest paid on the loan is usually tax deductible. It depends on your tax bracket and the amount of the loan, but the savings of such a tax deduction can be significant.

Types of Home Equity Loans

There are two types of home equity loans:

Home Equity Loan
Home Equity Line of Credit (HELOC)

Both are sometimes referred to as second mortgages, because they are secured by your property, just like the original, or primary, mortgage.

A home equity loan is a one-time loan for a set amount. You pay off the loan over a set period of time, with a fixed interest rate, and the payments are the same each month.

A home equity line of credit works like a credit card, and the interest rate fluctuates. You can have a revolving balance, taking out money as you need it by writing a check, using a credit card or having funds transferred to your bank account. As you pay on the loan and reduce the balance, you can borrow more money (up to the original loan amount). For example, if your home equity line of credit limit is set at $10,000 and you borrow $7,000 for a new roof, that leaves you with $3,000 to borrow -- or not borrow. Your payments would be based on the outstanding balance. While a home equity line of credit gives you more flexibility than a fixed-rate home equity loan, care should be taken not to fall into the "never out of debt" trap of always borrowing more as you pay the loan amount down.

With either a home equity loan or a line of credit, you have to pay off the balance when you sell your house.

Obtaining a Home Equity Loan

The process for obtaining a home equity loan is relatively simple.

First, do some research to determine which lender will provide the best interest rate on a home equity loan. Contact the lender of your choice and apply for the loan. You may have to pay for an appraisal of your home. (This amount, as well as any other loan fees, can usually be included in the loan itself so you won't have to come up with much out-of-pocket cash.) The lender will run a credit check on you and determine your credit score. Then, based on your credit score and other factors, the lender will determine the amount of credit they will extend, the interest rate you will pay for your loan, and the term (length of time) of the loan. The lender will provide you with these details, and then it's up to you to accept the terms and take out the loan.

Before taking on any financial obligations, it is important to understand the risks as well as the benefits.