What Is A Home Equity Loan?

Many people ask me what is a home equity loan. Many others confuse it with the basic refinance where you pay off your existing mortgage by replacing it with another loan. Basically, it is a second loan (your mortgage is the first one) that you take on your house. While your mortgage (the first loan) goes towards purchasing the house, the home equity loan is the sum you can spend as you wish.

Once the lender approves your home equity loan, you’ll get a check of the total approved amount. You will have to pay the agreed monthly installment for a fixed time period, usually 5 to 15 years.

Lenders are usually more liberal in giving home equity loans because they hold your home as collateral. You just can’t disappear with your house; neither can you hide it when you default on your loan. In case you default, they have full right to foreclose.

Benefits of Home Equity Loans

Borrowers are attracted to home equity loan because it provides an easy source of cash. Additionally, your credit history and credit score don’t really have any effect on the approval process. So, even people with bad credit can easily get a home equity loan. It’s primarily because your home is the collateral. Home equity loans can be tax deductible (we’ll discuss it within a few minutes). This type of loans have lower interest rates. Also, you can borrow relatively large sum of money.

How People Use Home Equity Loans

People use home equity loans to pay down some of the larger expenses in life such as renovating or remodeling the house, paying for college education of a family member, an unexpected medical bill or paying off the high interest credit card debts.

A home equity loan makes sense only if you want to invest that money into something that will have long-lasting benefits.

If you are a responsible borrower with a steady source of income, its tax deductibility on interests paid and lower interest rate makes it a lucrative alternative.

Jon Duncan, a Tacoma, Wash.-based certified financial planner, says, “a home equity is a sensible option only if you want to put that cash into something that will have long-lasting benefits.” He recommends a home equity loan if you need to pay down the credit card debts with high interest or renovate your house.

The Most Common Pitfalls

Remember that you risk losing your home if you default on the payment schedule. Many people are addicted to borrowing, spending, then borrowing more and sinking into deeper debts. Such people finally turn to home equity loans that allow them to raise 125 percent of the equity in their house. The interest rate increases because the borrower is raising more money than the house is worth. If you fall into this category of borrowers, DO NOT take out a home equity loan.

Another common pitfall is spending the funds on luxuries, vacations or other things that don’t add value to the house and increase the financial burden.

Beware of scammers! They have plenty of ways to cheat you out of your most valuable asset. Make sure you know everything about whoever you are dealing with. If you smell something fishy, step back, review and do a background check that the deal is legitimate.

Is Home Equity Loan Tax Deductible?

Yes, but not entirely. Generally, interests paid on the first $100,000 of your home equity loan will be tax deductible. Beyond that, it depends on how you spent the home equity loan. If it was used to renovate your home – or to purchase a second home – interests are deductible on up to $1 million or the value of the house.

Additionally, interests paid on the part of the loan above the value of the house is not tax deductible. For example, let’s say your home is worth $100,000, of which $80,000 is the first mortgage. Here, your home is worth only $20,000 more than the actual debt. But you can borrow $45,000 under the 125 percent program. So, the interests paid on the first $20,000 will be tax deductible, and not on the entire $45,000.

Home equity loans are a good option, but only for the responsible borrowers. Next week, I will tell you how to get a home equity loan quickly and easily.

Do you have any questions? I’d like to help. Leave a comment.

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