How Do Home Equity Loans Work?
A home equity loan, also known as a second mortgage, lets homeowners borrow money by leveraging 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 they file their tax returns.
The problem for homeowners is that this tax-deduction bliss did not last. The Tax Cuts and Jobs Act of 2017 removed the tax deduction starting in 2018, except if you use the money for qualified home renovations (the phrase in the law is “buy, build, or substantially improve” the home that secured the loan).
There are, nonetheless, still several other good reasons to take out home equity loans, such as their relatively low interest rates compared with other loans, but a tax deduction may no longer be in the cards for them.
How Do Home Equity Loans Work?
Home equity loans come in two varieties, fixed-rate loans and revolving lines of credit.
Fixed-rate loans provide a single, lump-sum payment to the borrower, which 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 lifetime of the loan.
Home Equity Lines of Credit (HELOCs)
A home equity line of credit (HELOC) is an adjustable or variable-rate loan that works much like a credit card and, in fact, sometimes comes with one to 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.
Benefits for Consumers
Home equity loans provide an easily accessible source of available cash. The interest rate on a home equity loan—although typically higher than that of a first mortgage—is still much lower than the rates on credit cards and other consumer loans. Indeed, a popular reason consumers have for borrowing 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, though no more tax benefits.
Benefits for Lenders
This loans are also a dream come true for 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. If the borrower defaults, the lender not only gets to keep all the money earned on both the initial mortgage and the home equity loan; it also gets to repossess the property, sell it again, and restart the cycle with the next borrower. From a business-model perspective, it is tough to think of a more attractive arrangement.
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