Homeowners with equity in their property can take out a home equity loan that uses their home as collateral. A home equity loan, also sometimes called a second mortgage, is a lump-sum loan, usually with a fixed interest rate and a specific loan term. Homeowners can also consider a home equity line of credit, which is a similar loan but has a variable interest rate and works akin to a credit card with a set spending limit.
Home equity loan benefits
If you have enough equity in your home to qualify for a home equity loan, usually at least 10 or 20 percent or more depending on the lender, you may want to consider how you would use the home equity loan funds. A home equity loan is distributed in a lump sum, so many people use one to consolidate debt, to pay an unexpected medical bill or tax bill or perhaps to make home improvements.
The interest you pay on a home equity loan is tax-deductible on loans up to $100,000.
Typically, while home equity loan interest rates are higher than interest rates on your first mortgage, the rates will usually be significantly lower than the interest rates charged on credit cards or other kinds of consumer debts.
Home equity loan pitfalls
While lower than closing costs on a first loan, you will usually have to pay for an appraisal and some fees when you take out a home equity loan.
While consolidating your debt into one payment can help you get out of debt faster, you must be disciplined enough not to begin using the available credit on your credit cards. You could end up with unmanageable levels of debt.
Since home equity debt is tied to your home, if you cannot repay the loan you are in danger of defaulting on the loan and losing your home. Careful budgeting is required to make sure you can handle the extra loan payment each month on top of your housing costs and other expenses.
A lender or a financial planner can help you evaluate the pros and cons of a home equity loan.
Michele Lerner contributed to this answer
A 25-year expert observer of the mortgage and consumer debt markets, Keith Gumbinger has been cited in thousands of articles covering a wide range of consumer finance and economic topics in outlets ranging from the Wall Street Journal to the Bottom Line newsletters. He has been a featured guest on national broadcasts for CNN, CNBC, ABC, CBS and NBC television networks and has been heard on NPR and other national and local radio programs. Keith is the primary researcher and writer for HSH.com's MarketTrends newsletter and has authored or co-authored a number of consumer guides on mortgages, home equity, refinancing and more.
