What is a Home Equity Loan
Home equity loans, also known as second mortgages, are loans that require repayment over a fixed timeframe. Home Equity Loans can be used to consolidate debt while at the same time the interest on the loan is tax deductible.
Home Equity Loan Definition
The traditional home equity loan, commonly known as the “second mortgage” is simply a loan keyed to the equity in your home. This traditional second mortgage loan provides you with a fixed lump sum of money immediately. The home equity loan is repayable over a fixed period, usually in equal monthly installments that will pay off the entire loan within that time. The interest rates on home equity loans are ordinarily fixed for the life of the loan.
A home equity loan can be either a fixed rate mortgage or an adjustable rate mortgage. Funds borrowed from the traditional home equity loan start accruing interest immediately after the lump sum is disbursed. Once you get the money, you cannot borrow further from the loan. The interest on your home equity loan is almost always tax deductible.
Interest Deduction for Home Equity Loans
To qualify to deduct the interest on your home equity loan, you must deduct the lesser 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 Loan Conditions
The conditions for home equity loans are similar to that of the conditions for home mortgage interest, with the exception being that the amount you can deduct is smaller.
- Total home equity debt cannot exceed $100,000.
- The debt must be secured by your residence.
- The debt can apply to your main or second home.
- You are personally obligated for repayment of the debt.
Home Equity Loan Example
Nathan Brandt purchased a house in New Jersey in 2008 for $300,000 with a mortgage of $250,000. In 2013, the mortgage is $230,000 and the value of his house is now $400,000. Nathan decided to take out a home equity loan. Interest on a home equity loan of up to $100,000 is fully deductible. Notice that his house has appreciated to $170,000 ($400,000 – $230,000) but he may only deduct up to the threshold amount of $100,000.
Home Equity vs. Home Equity Line of Credit
There is a specific difference between a home equity loan and a home equity line of credit (HELOC). A HELOC is a line of revolving credit with an adjustable interest rate whereas a home equity loan is a one time lump-sum loan, often with a fixed interest rate.
General Home Equity Loan Facts
The second mortgage carries rights which are subordinate to those of the first. Lenders who are in the first position have the primary lien against the property. They would be able to foreclose on the property should a borrower default because of their primary lien position. The second lien position relates to the amount of money loaned and that second position. A second lien holder would find much more difficulty foreclosing on the property. This is the reason second mortgage rates are typically higher than first mortgage rates, to compensate for the higher risk.
The traditional home equity loan is generally used to consolidate other debt with high interest rates (like credit card debt), to finance large expenses (like a wedding or college education), or to purchase other costly items (like a new car or an investment property). Home equity loans are usually for a shorter term than first mortgages. Equity loans typically have a life of five to fifteen