Home Equity Loans
What is a home equity loan?
A home equity loan is a loan that uses your home as collateral. Your home equity is the part of your home that you actually own and this is the guarantee for your loan.
Your home equity is calculated by taking the current value of your home and subtracting your mortgage. For example, if your home is worth $150, 000 and you have a $100,000 mortgage, you have $50,000 of equity in your home. A home equity loan allows you to borrow money using your equity of $50,000 as security for the loan.
A home equity loan, often called a second mortgage, reduces your equity or ownership in your home. Since your home guarantees your loan, if you default on the payments, you can lose your home.
Advantages / Disadvantages to getting a home equity loan
A lower interest rate and tax deductions are the two major advantages home equity loans have over other types of debt.
Since a home equity loan is secured by your home, it poses less risk to a lender than does a non-secured personal loan or credit cards - this lower risk is passed on to you in the form of a lower interest rate.
The second major advantage is that regardless of the way a home equity loan is used, the interest you pay on the first $100,000 you borrow is tax deductible. Credit cards and other types of non-secured loans do not have this tax benefit. This means that if you pay $3,000 in interest on your home equity loan, you will reduce your taxable income by $3,000 at the end of the year. If you use a home equity loan for home improvements or to buy another home, you can deduct the interest paid on the first $1 million that you borrow. The reason for this is that home improvement loans are similar to first mortgages for tax purposes. You should consult a tax advisor about the specific tax benefits available to you.
The biggest drawback of a home equity loan is the fact that your home is on the line and you could lose your home if you default on your payments. When you borrow from your home's equity you also reduce the equity or ownership you have in your home. This means that you trade ownership or equity in your home for cash that you will use for some some other purpose. In addition to interest you will pay on the loan, there are also costs associated with taking out a home equity loan - these costs are similar to the costs you paid when you bought your home.