Home Equity Definition
Home equity is the current market value of a home minus the remaining mortgage balance. It is essentially the amount of the home that you own outright. For example, if your home is worth $250,000 and the principal balance remaining on your mortgage is $175,000, then your home equity portion of your home is $75,000. By using the equity in your home, you may qualify for a sizable amount of credit at an interest rate that is relatively low.
Typically, residential property is bought through a mortgage, which is then paid off over a number of years, often 15 or 30. After the mortgage has been fully repaid, the property then belongs to the mortgagor (the borrower in a mortgage agreement), namely the buyer. In the interim, however, the buyer simply builds up equity in the home. This is what a home equity loan borrows against. Although that equity cannot be sold, banks will lend money against it.
Home Equity Loans
There are two main types of home equity loans:
Home Equity Tax Break
These two types of loans offer significant tax savings due to the fact that the interest paid on them is tax deductible. Interest on credit card and other consumer debt is “personal” interest that is not deductible. If you were to consolidate these loans into a home equity loan, the interest you pay is transformed into deductible home mortgage interest.
To qualify to get the tax deductions for the interest on your home equity loan, the loan must be “home equity indebtedness”. This is a mortgage that meets the following two requirements:
- 1. The home equity loan must be secured by a mortgage either on your principal residence or a second home you select for purposes of getting the interest deduction.
- 2. The total amount that may qualify as home equity indebtedness, on a principal residence and second home combined, cannot exceed $100,000, or $50,000 if married filing separately.
Home Equity Credit Limit
Lenders generally set the credit limit on a home equity loan by taking a percentage, 80% for example, of the appraised value of the home, reduced by the balance owed on the mortgage. For example, if your home is worth $250,000 and the balance of the mortgage on your home is $150,000, you might be able to get a $50,000 home equity mortgage determined as follows:
|Value of home||$ 250,000|
|Credit limit percentage||X 80%|
|Adjusted Appraised Value||$ 200,000|
|Less Mortgage Debt||($150,000)|
|Potential home equity loan||$ 50,000|
Home Equity Examples
See more home equity loan examples and learn about the “ceiling rule” (Home Equity Debt higher than your limit).
Home Equity Debt Limit
There is a limit on the amount of debt that can be treated as home equity debt. The total home equity debt on your main home and second home is limited to the smaller of:
- 1. $100, 000 ($50,000 if married filing separately), or
- 2. The total of each home’s fair market value (FMV) reduced (but not below zero) by the amount of its home acquisition debt and grandfathered debt. Determine the FMV and the outstanding home acquisition and grandfathered debt for each home on the date that the last debt was secured by the home.
Home equity debt example 1: Justin Zimmerman owned a single home that he bought in 1999 in Ventura, CA. It’s FMV now is $110,000, and the current balance on his original mortgage (home acquisition debt) is $95,000. Bank of America offers Justin a home mortgage loan of 125% of the FMV of the home less any outstanding mortgages or liens. To consolidate some of his debts, Justin takes out a $42,500 home mortgage loan [(125% x $110,000) – $95,000] with Bank of America.
Justin’s home equity debt is limited to $15,000. This is the smaller of:
- $100,000 maximum limit
- $15,000, the amount that the FMV of $110,000 exceeds the amount of home acquisition debt of $95,000.
Debt Higher Than Limit
Interest on amounts over the home equity debt limit generally is treated as personal interest and is not deductible. But if the proceeds of the loan were used for investment, business, or other deductible purposes, the interest may be deductible.
Home equity debt example 2: In the example above, Justin cannot deduct the $27,500 ($42,500 – $15,000) amount above his limit. This is treated by the IRS as personal interest and is not deductible.
Never Default on Your Home Equity Loan
If you default on a home equity loan, the lender could foreclose on your home. You should NEVER agree to a home equity loan if you can’t afford the monthly payments. If you get in over your head, you could lose your home.
Canceling a Home Equity Loan
Can you cancel a home equity loan? Via, the Truth In Lending Act, the answer is yes but there are rules.
A final note on home equity loans, be aware that when you sell your home, you probably will be required to pay off your home equity line in full.