A home equity loan is a type of consumer debt, allowing homeowners to borrow money against the equity in their home. Other names for a home equity loan include equity loan, home equity installment loan or simply a second mortgage.
The loan amount is determined by calculating the difference between the home’s current market value and the homeowner’s remaining mortgage balance. Usually, home equity loans are fixed-rate mortgages. Sometimes borrowers will choose a home equity line of credit (HELOC), which is another type of equity loan, but it has a variable rate.
Breaking Down the Home Equity Loan
For a home equity loan, a borrower’s home serves as collateral. To determine the amount of the loan, first the home needs to be appraised to determine its value. Generally, the loan-to-value ratio should be around 80 to 90% of the home’s value. Once the loan amount is determined, lenders will look at your credit score and payment history to determine the loan interest rate.
In a standard home equity loan, there is a predetermined repayment term, just like a regular mortgage. During the repayment term, the borrower makes regular payments to cover the principal and fixed interest for the loan. As is the case with a typical mortgage, if the borrower can’t pay off the debt, then the lender can force them to sell the home to receive their payments.
Why Do People Get Home Equity Loans?
Oftentimes, a home equity loan could be a good way to pay for renovations on your home. Homeowners can turn their built-up equity into cash and invest in renovations, which will then increase the value of their home.
However, it’s important to note that market changes could still leave you owing more than your house is worth in the end, so there’s always some amount of risk involved.
Other times, people take out home equity loans to pay off other forms of debt, like credit card debt. This dynamic is a slippery slope because people can continue to run up their card bills, creating a debt spiral that puts their home at risk.
Pros and Cons of Home Equity Loans
- Home equity loans are easy to obtain.
- They have lower interest rates than other types of loans.
- Home equity loans come with a potential tax deduction for interest paid.
- Because home equity loans are easy to obtain, they could lead to a debt spiral.
- Home equity loans could lead to your house foreclosure if you can’t pay off the debt.
For commercial real estate investors who buy residential properties, a home equity loan can be a good option if you’re looking to purchase another residential property to use as a single-family rental. Nonetheless, it’s always a good idea to speak to a financial advisor to make sure you’ll be able to manage the different types of loans.