How does a home equity loan work?

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A home equity loan is also known as a second mortgage.

Also known as a second mortgage, a home equity loan is a loan against the value in your home. You borrow from what's called your home equity, which is the amount your home is worth minus the amount you still owe on it.

You should have a nice amount of home equity to tap into if you've been paying down your primary, or first, mortgage. It also helps if the market value of your home has been going up.

Home equity loans became very popular following the passage of a tax law in 1986. The law killed the deduction for interest paid on credit cards, car loans and other consumer borrowing, but it allowed Americans to keep deducting the interest on home loans.

That led homeowners to rely on home equity loans whenever they needed a big chunk of cash, because they could write off the interest.

Today, home equity loans are less of a free-for-all for taxpayers, thanks to the 2017 tax law. Today, you're limited to deducting the interest only when a home equity loan is used to buy, build or make major improvements to a home.

Why home equity loans?

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Home equity loans are a good choice when you're doing a home renovation.

The deduction helps make equity loans a popular choice when homeowners need money for a major renovation, such as adding a new bathroom (to stop the kids from fighting over the sole bathroom upstairs), putting on a new roof, or completely redoing the kitchen.

Chances are you're somebody who could benefit from a home equity loan. About half (48%) of U.S. homeowners plan to renovate in the next two years, and a third of those remodeling jobs will cost more than $50,000, a survey from TD Bank found.

You receive the proceeds from a home equity loan in a lump sum, which is perfect when you have a fixed budget for your project.

Often, there's a minimum amount you must borrow, typically ranging from $10,000 up to $25,000. On the other end, the loans usually have maximums, too.

Home equity loans, which use your house as collateral, come with fixed interest rates, and you can choose a repayment term of between five and 30 years.

Because the loans are secured, you might qualify for a home equity loan even if your credit score isn't spectacular. But if your score is way down below 620, you'll need to work on fixing it, because you'll probably have a tough time finding a lender.

Pros and cons of home equity loans

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Weigh all of the advantages and disadvantages before you agree to a home equity loan.

Home equity loans have their advantages and disadvantages. The plus side of borrowing from home equity includes:

  • Steady interest rates. You won't have to worry about any surprise rate increases the way you do with variable-rate loans.
  • Attractive interest rates. The rates are much lower than the rates on credit cards and can be lower than the APRs on personal loans.
  • Quick closings. The loans close faster than other types of home loans, including cash-out refinances. (We'll explain those in just a bit.)
  • Tax breaks for remodelers. The interest can be deductible if you use your loan proceeds for a major home project.

And here are some of the minuses:

  • Risks to your home. Because the loan is secured by your house, you could wind up losing it if you don't pay the money back.
  • Not as flexible as other options. A home equity loan isn't the right choice if you need just a few thousand dollars.
  • The costs. You pay closing costs and fees that usually total 2% to 5% of the loan amount, according to LendingTree.

Home equity loan requirements

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You'll need to do some simple math to determine your potential loan amount.

To take out a home equity loan, you'll (obviously) need to have some equity built up in your home. MATH ALERT: We have to warn you that there's some math coming, but it's really not that complicated.

Here's a simple way to get a rough idea of your equity: Find your house on one of the many real estate websites that give estimated home values. Then, just take the estimate and subtract the balance left on your first mortgage.

For example, if the site says your house is worth $400,000 and you've got a $200,000 mortgage balance, your equity would be $200,000.

Lenders typically cap home equity loans at 80% of a house's value. So, going back to the example, a loan would be limited to 80% of $400,000 — or $320,000.

But you wouldn't be able to borrow that much, because of the $200,000 you owe on your first mortgage. Subtract it from $320,000, and you have your maximum loan amount: $120,000.

Now that wasn't so bad, was it?

Not sure about a home equity loan?

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If you have doubts about a home equity loan, you have options.

If you're not quite sold on a home equity loan, you do have alternative types of loans.

You may decide a home equity line of credit, or HELOC is a better way to go. With a HELOC, you're not given a lump sum but instead can draw money from your available equity as you need it.

HELOC interest rates are variable, and you're charged interest only on the money you use, not on the entire credit line.

You also have the option of making interest-only payments during the first several years, while you have the ability to tap the line. Once that draw period ends, you enter the repayment period.

Another option is a cash-out refinance. You replace your first mortgage with a new loan bigger than the amount you owe on your home, and you take the extra cash from your equity. As with HELOCs and home equity loans, you pay closing costs, and the loan is secured against your home.

The Federal Housing Administration (FHA) recently tightened cash-out refis, limiting the loans to 80% of a home's fair market value. Previously, you could borrow up to 85% of your equity.

Or you might look into a personal loan from a bank, a credit union or an online lender. The loans can be either unsecured — meaning no collateral is necessary — or secured by something of value, like your house.

An unsecured personal loan won't put your home on the line if you're unable to pay, but you'll need good credit to be approved.

Personal loans offer more flexibility than home equity loans, because you can borrow smaller amounts. The interest rates can be lower or much higher than home equity rates — it largely depends on your credit score.

The bottom line on home equity loans

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Consider whether a home equity loan is right for you.

In short, home equity loans are an option that's available to you if you own your home and need to access credit.

They're great for paying for home improvement projects — like adding a new bathroom for your growing family — but they're also risky.

Because a home equity loan can put your house in jeopardy if life happens and you have trouble with repayment, you might just want to keep the alternatives on your radar.