A home equity loan is money borrowed using your property as collateral. It is often called a second mortgage because you add an additional lien, or claim of ownership, against your home if you fail to repay the debt. This type of loan has pros and cons compared to unsecured personal loans.
Since you use your home as collateral, a home equity loan is a secured loan. The lender generally assumes a second lien position, meaning it has second dibs on the property if you go into foreclosure. The good news is you normally get a lower interest rate on a secured loan than an unsecured loan. Typically your equity loan is based on the equity you have accrued by paying down your existing mortgage. Lenders commonly issue equity loans that allow a combined loan-to-value ratio of as much as 90 percent to 100 percent.
A home equity loan is distributed in a lump sum, as opposed to a home equity line of credit, through which you get open access to a certain amount of funds. The loan approach usually makes sense if you know exactly what you need to borrow, such as with a business start-up or home improvement project. When you are uncertain of how much you need and want more flexibility, a HELOC makes sense.
Home equity loans are repaid on amortized schedules similar to your first mortgage loan. The repayment period is generally shorter, such as five to 10 years. Each installment includes a portion to principal and interest on the balance. This is different than a HELOC, for which you can make interest-only payments during the initial draw period. This is the first five to 10 years when you have access to the available limit.
Typically, you can use home equity loans for any purpose. Lenders presume your intentions are sound if you meet basic credit requirements and you stake your property to the loan. In some cases, banks call equity loans home improvement loans or by other specific names to designate a certain use. Homeowners sometimes use home equity loans to consolidate more expensive credit card debt into a single, low-interest loan. Paying for kids to go to college is another common use. The website Nolo indicates that financial experts advise against getting secured loans for non-essential, luxury purposes.
Neil Kokemuller has been an active business, finance and education writer and content media website developer since 2007. He has been a college marketing professor since 2004. Kokemuller has additional professional experience in marketing, retail and small business. He holds a Master of Business Administration from Iowa State University.