A home equity loan, also known as a second mortgage, lets homeowners borrow money by drawing on the equity value in their homes. Home equity loans exploded in popularity in the late 1980s, as they provided a way to somewhat circumvent the Tax Reform Act of 1986, which eliminated deductions for the interest on most consumer purchases. With a home equity loan, homeowners could deduct all of the interest when filing their tax returns.
However, the tax deduction was modified with the passage of the Tax Cuts and Jobs Act of 2017. Starting in 2018 and ending after 2025, you may deduct the interest paid on a home equity loan as long as the money is used for qualified home renovations or to “buy, build, or substantially improve” the home, according to the Internal Revenue Service (IRS).
Nonetheless, there are still several benefits to home equity loans, such as their relatively low interest rates compared with other loans. However, you can no longer receive an interest tax deduction if you use the funds for personal purchases or to consolidate credit card debt.
Key Takeaways
- A home equity loan allows you to tap into the equity in your home and use it as cash.
- The two types of home equity products include fixed-rate loans and variable-rate equity lines of credit (HELOCs).
- Interest paid on home equity loans is tax-deductible if the funds are used to buy, build, or substantially improve the home securing the loan.
- Both types of loans must be repaid in full if the home on which they are borrowed is sold.
How Do Home Equity Loans Work?
Home equity loans come in two varieties: Fixed-rate loans and revolving lines of credit. With both types of credit, you’re borrowing money based on a percentage of the appraised value of your home minus any outstanding mortgage debt. Typically, you may be able to borrow up to 80% of the home’s value, assuming there’s no first mortgage loan.
Your home is used as collateral for the loan. As a result, if you don’t repay the loan or line of credit, the mortgage lender can foreclose, meaning the bank takes possession of the home and sells it to recoup the loan proceeds.
Fixed-Rate Loans
Fixed-rate loans provide a single, lump-sum payment to the borrower. The loan is repaid over a set period of time, usually five to 15 years, at an agreed-upon interest rate. The payment and interest rate remain the same over the loan’s lifetime.
Home Equity Lines of Credit (HELOCs)
A home equity line of credit (HELOC) is an adjustable or variable-rate loan that works like a credit card. Sometimes, these loans come with a credit card that the borrower can use for purchases on the line of credit. Borrowers are pre-approved for a certain spending limit and can withdraw money when they need it via a credit card or special checks.
Monthly payments vary based on the amount of money borrowed and the current interest rate. The draw period, usually five to 10 years, is followed by a repayment period when draws are no longer allowed, generally 10 to 20 years. Though HELOCs typically have a variable interest rate, some lenders may convert to a fixed rate for the repayment period.
Popular usages for home equity loans include paying off credit cards, home improvements, and paying for college.
Benefits for Consumers
Home equity loans provide an easily accessible source of available cash. Although the interest rate on a home equity loan is typically higher than a first mortgage, it is still much lower than the rates on credit cards and other consumer loans. As a result, a popular reason consumers borrow against the value of their homes via a fixed-rate home equity loan is to pay off credit card balances.
By consolidating debt with a home equity loan, consumers get a single payment and a lower interest rate. However, they will not receive a tax deduction on the loan interest.
Benefits for Lenders
Home equity loans also benefit the lender. After earning interest income and fees on the borrower’s initial mortgage, the lender earns even more interest and fees on the home equity debt or second mortgage. If the borrower defaults, the lender can repossess the property and sell it to recover the loaned funds—this is called foreclosure.
However, the primary business of a lender is loaning money, not taking possession of homes to resell them. As a result, lenders usually will work with borrowers to find a payment arrangement to avoid foreclosure.
If you default on a home equity loan, you could end up losing your collateral—your home.
The Right Way to Use a Home Equity Loan
Home equity loans can be valuable tools for responsible borrowers. If you have a steady, reliable source of income and know that you will be able to repay the loan, its low interest rate makes it a sensible alternative.
Fixed-rate home equity loans can help cover the cost of a single, large purchase, such as a new roof on your home or an unexpected medical bill. A HELOC provides a convenient way to cover short-term recurring costs, such as the quarterly tuition for a four-year degree at a college.
Recognizing the Pitfalls
The main pitfall associated with home equity loans is that they sometimes seem to be an easy solution for borrowers who may have fallen into a perpetual cycle of spending and borrowing, spending and borrowing—all the while sinking deeper into debt.
Reloading
Unfortunately, this scenario is so common that lenders have a term for it: “reloading,” which is the habit of taking a loan to pay off existing debt and free up additional credit, which the borrower then uses to make additional purchases. Reloading can lead to a spiraling cycle of debt that often convinces borrowers to turn to home equity loans offering an amount worth 125% of the equity in the borrower’s house. This type of loan often comes with higher fees because, as the borrower has taken out more money than the house is worth, the loan is not secured by collateral.
If you are contemplating a loan worth more than your home, it might be time for a financial reality check. Were you unable to live within your means when you owed only 100% of the value of your home? If so, it will likely be unrealistic to expect that you’ll be better off when you increase your debt by 25%, plus interest and fees. This could become a slippery slope to bankruptcy.
Home Improvements
Another pitfall may arise when homeowners take out a home equity loan to finance home improvements. While remodeling the kitchen or bathroom may add value to a house, improvements such as a swimming pool may be worth more in the eyes of the homeowner than in the market. If you’re going into debt to make changes to your house, determine whether the changes add enough value to cover their costs.
Paying for College
Paying for a child’s college education is another popular reason for taking out a home equity loan. However, especially if borrowers are nearing retirement, they need to determine how the loan may affect their ability to accomplish their goals. It may be wise for near-retirement borrowers to seek out other options. Note that either type of home equity loan must be repaid immediately in full if the home against which they are borrowed is sold.
Can I Deduct the Interest Paid on a Home Equity Loan?
You can deduct the interest paid on a home equity loan if the borrowed funds are used for qualified home renovations, meaning to “buy, build, or substantially improve” the home, according to the Internal Revenue Service (IRS). However, you cannot deduct the interest if the funds were used to consolidate credit card debt or for personal purchases.
What Is the Downside of a Home Equity Loan?
Typically, a home equity loan has a higher interest rate compared to a mortgage loan. Your home is also used as collateral for the loan. As a result, it’s important not to borrow more than you can repay. If you default, the bank may foreclose and take the home.
What’s the Difference Between a Home Equity Loan and a Home Equity Line of Credit (HELOC)?
You receive a lump sum upfront with a home equity loan and are charged a fixed-rate of interest with fixed monthly payments over the life of the loan. Conversely, a home equity line of credit provides you with a credit line that you draw on for up to ten years. The HELOC comes with a variable interest rate, meaning the rate can go up or down.
The Bottom Line
Home equity loans provide many benefits that allow you to borrow money off the equity in your home. The loan can be used for various purposes, including home repairs, consolidating high-interest-rate debt, or paying for a child’s education.
However, it’s important not to borrow more than you can repay since your home is used as collateral for the loan. In the event of default or nonpayment, the bank can foreclose, meaning it takes the home and sells it to recoup the loaned funds.
To avoid the pitfalls of reloading, carefully review of your financial situation before borrowing against your home. Also, be sure that you review the home equity loan draw period and repayment terms.