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Basic uses for home equity loans

Debt consolidation and home improvements are the most common reasons homeowners borrow from their equity, says Greg McBride, CFA, chief financial analyst for Bankrate. There are other reasons borrowers may tap home equity such as education costs, vacations or other big ticket purchases.

Under the Tax Cuts and Jobs Act of 2017, borrowers can deduct the interest paid on HELOCs and home equity loans if they use the funds to buy, build or improve the home that acts as collateral for the loan.

Home equity loans have ranged from 5.88% to 5.97% in 2019 while a $30,000 home equity line of credit has ranged from 6.52% to 6.78%.

One drawback is that home equity loans and lines of credit have closing costs and fees similar to a standard mortgage. Closing costs vary but can run into the thousands of dollars based on the value of a property.

How home equity loans work

Homeowners can either obtain a home equity line of credit known as a HELOC or a home equity loan. The amount of equity you have available is determined by subtracting the amount you still owe on your mortgage from the value of your house. The difference is the amount of equity.

Home equity loans, also known as a second mortgage, use your home as collateral. The advantage of a home equity loan is that the homeowner receives a lump sum of money at a fixed interest rate. A home equity loan typically has a term of five to 20 years, but the amount you can borrow is often limited to 85 percent of the equity of the home.

“Home equity borrowing can still be a low-cost source of funds, particularly for homeowners with other assets that they are unwilling or unable to liquidate easily,” McBride says. “Using home equity to buy, build or improve a home is still potentially tax deductible, so prospective borrowers should be sure to consult a tax advisor regarding their specific situations.”

A HELOC operates like a credit card because it has an extended draw period and rates are typically variable. The average term is 10 years, which means a homeowner can borrow money as it as needed.

Homeowners who are facing several remodeling projects with different lengths, ranging from adding a new stove to adding a new room, might find a HELOC fits their needs the best.

Paying for a major home improvement with this type of loan can be a good way to add value to the home and spread the payments over time, says Jim Triggs, a senior vice president of counseling and support of Money Management International, a Sugar Land, Texas-based non-profit debt counseling organization.

When these loans are used for home improvement or to purchase of another property, a home equity loan could be more like an investment, says Bruce McClary, spokesperson for the National Foundation for Credit Counseling, a Washington, D.C.-based non-profit organization.

“It's important to make sure that the work performed on your home adds long-term value and that the additional property returns more in rental income that you have to pay for the loan,” he adds.

Both types of home equity loans have downsides.

“Tapping home equity may use up valuable borrowing capacity that is unavailable later,” McBride says. “Using home equity to consolidate debt puts the home at risk in the event of default and unless the root cause of the debt is addressed, it does nothing more than move the money around.”

When a homeowner consolidates credit card debt with a home equity loan, taking steps to avoid accruing more debt on the same credit cards is important, says McClary.

“It could leave you with double the debt and fewer affordable repayment options,” he says.

Defaulting on credit card debt has consequences, but it may not be as detrimental as defaulting on mortgage payments, including a home equity loan, Triggs says.

“Another disadvantage is that if a person runs into financial issues, getting renegotiated terms on a home equity loan could be difficult, if not impossible compared to credit card companies, which will usually work with an individual if a true hardship such as loss of a job occurs,” he says.

Keep in mind that if you fail to repay a home equity loan as agreed, the lender can foreclose, and you could lose your home.