How Does a Home Equity Loan Work?

People who find themselves facing dire financial situations or who need money to cover unexpected expenses or those for which they have not budgeted well may consider a home equity loan. People have obtained home equity loans in increasing numbers with Americans borrowing more than $400 billion in home equity loans and lines of credit in 2004. These people often fail to ask the most basic question, however. How does a home equity loan work?

First, we must differentiate between a home equity line of credit and a home equity loan. The basic difference is simple. A home equity loan means that a bank approves you for a set amount of money, which you receive in a lump sum. A home equity line of credit means that you receive the approval for an open line of credit. You can receive payments from this line of credit until you reach the maximum permissible.

A home equity loan works in a fairly simple way. Purchasing a home means building equity. The equity is the difference between the value of your home and the amount you have owe on the home’s principal. To make that easier to grasp, let’s use real numbers. If your home is worth $100,000, and you have $30,000 remaining on your mortgage, subtract it from $100,000. You have $70,000 in equity on your home.

Still, you may be wondering: how does a home equity loan work? The concept is simple. You own a home, which for most people is their largest financial asset. You also have credit card debt or a child going to college – for which you have not prepared – or some other major financial obligation. Getting a home equity loan is simple because it’s built-in credit. You borrow the money and pay it back in monthly installments, as you would any other loan.

The benefits are simple, too. Some of the interest you pay on a home equity loan – and all of it if you use it for home repairs – is tax-deductible. There are federally-mandated limits on this deduction, but for the average family, all of the payments will be deductible. You can deduct up to $100,000 of a home equity loan on your primary residence regardless of the reason for the loan and $1 million if you are conducting home repairs.

The second benefit is that a home equity loan generally will have a lower interest rate than personal loans or other loans that you may consider. That makes them a sound financial option if you must loan money.

The downside of a home equity loan, or second mortgage, is that you are putting your home on the line. If you can pay your bills but need the money for major medical expenses, for example, it could be a wise decision because you will be able to pay it back. If, however, you are consolidating debt without a plan for changing your spending habits, you could get yourself into more debt and end up losing your home. These loans are risky, so take them wisely.