What is a Home Equity Loan and How Does It Work?

Years ago, banks were not permitted to make second mortgages, and the people who borrowed money secured by a second mortgage were perceived to be in financial difficulty.

When new laws were enacted, allowing banks to make loans for personal, family, or household purposes secured by a second mortgage (often referred to as a “junior mortgage”), their marketing staff coined the term “Home Equity Loans” to change that perception—and it worked! 

Today, Home Equity Loans represent a substantial share of the mortgage industry, with more than two billion dollars of Home Equity Loans being originated annually. This enables consumers to finance major expenses such as home repairs, medical bills, or college education.   

There are two types of Home Equity Loans. The first, simply referred to as a “Home Equity Loan,” falls under the category of “Closed End Credit.” It consists of a traditional loan, where you borrow a single lump sum and repay the loan by making constant monthly payments.

The second, referred to as a Home Equity Line of Credit, or, its acronym, a “HELOC,” falls under the category of “Open End Credit.” It, too, requires monthly payments but allows the borrower to continuously borrow any amounts needed, up to the amount of the “credit line,” just like a credit card.

Both the traditional Home Equity Loan and the HELOC are typically secured by a second mortgage that is subordinate to the first mortgage. As a result, the Home Equity Loan includes the obligation of the borrower to not only pay the Home Equity Loan, but also to pay the first mortgage, real estate taxes, and insurance. Failure to pay any of these obligations will constitute a default under the mortgage securing the Home Equity Loan, and the Home Equity Lender will have the right to foreclose its second mortgage.

The Benefits of the Home Equity Loan                           

One benefit of a Home Equity Loan is that you need not refinance your existing first mortgage if its interest rate is lower than the current prevailing rates. Since the Home Equity Loan is generally much smaller than the first mortgage, the higher interest rate on the home equity loan is usually far less costly than refinancing the first mortgage at a higher interest rate would be.  

Another benefit is that the interest is tax deductible. Years ago, all interest was tax deductible; however, the laws have changed. Today, only margin interest on securities and interest from loans secured by a mortgage on your principal residence (such as a Home Equity Loan) are tax deductible. If you have a substantial amount of credit card debt, a Home Equity Loan would allow you to consolidate them, reduce the monthly payments and benefit from the new monthly payments being tax deductible.  

Whether you are considering a traditional Home Equity Loan or a HELOC, it is important to remember the old adage: “There is nothing wrong with borrowing; only with borrowing wrong.” 

If you have questions about whether this type of loan is right for you, please contact me at peter.roach@roachlawfirm.com.

Peter Roach

Peter T. Roach & Associates, P.C.

peter.roach@roachlawfirm.com