What Is a Home Equity Loan, and When Is It Better Than a Mortgage?

Understanding different home loan types is important.

Aug 17, 2014 at 12:00PM

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Source: 401(k) 2012 via Flickr.

The housing crash of the late 2000s and the financial crisis that followed it made "mortgage" a bad word for millions of homeowners who found themselves underwater on their home loans. Yet since then, home prices have started to recover, and in some areas, they've climbed appreciably from their worst levels. As a result, many homeowners actually have equity in their homes again, and getting access to that equity has some value in helping them reach their financial goals. Home equity loans can help, but what is a home equity loan, and how is it different from a regular mortgage?

Read on to get a closer look at home equity loans and whether they're right for you.

What is a home equity loan?

A home equity loan is a loan that uses your home as collateral. As with a mortgage, the lender on a home equity loan has the right to foreclose on your home if you fail to repay according to the loan's terms. In general, though, home equity loans are subordinate to mortgage loans, meaning that in the event of a foreclosure, the mortgage lender gets repaid from the proceeds of sale first, and any remaining amount is available to the lender of the home equity loan. As a result, home equity loans tend to be riskier from a lender's perspective, as there usually isn't as much collateral value standing behind the loan as there is with a mortgage.

Homeowners typically use mortgages to finance their original home purchase, and mortgage refinancing sometimes provides additional amounts as an opportunity to tap rising home equity. But more often, homeowners use home equity loans for additional financing, whether it be for home-related purposes such as remodeling or renovation or for unrelated expenses like education or consolidating other forms of debt.

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Source: Mark Moz via Flickr.

Home equity loans come in two different types: fixed-rate loans and home equity lines of credit. Fixed-rate loans typically involve a single advance of funds that you repay with monthly payments just like a regular mortgage. Lines of credit, on the other hand, are more flexible, typically having variable rates and allowing you to draw amounts at any time you choose up to the maximum value of the line of credit.

Why are home equity loans popular?

One big reason why so many homeowners use home equity loans is for the opportunity to deduct the interest they pay. The tax laws provide that you can deduct interest on up to $100,000 in home equity debt even if it's not used for the purpose of making substantial improvements to your home. By contrast, most other forms of loans don't qualify for a tax deduction, making borrowing even more expensive.

During the housing boom, home equity loans helped fuel a rise in consumer debt generally. Homeowners would accumulate debt on credit cards and then use home equity loans to replace high-interest-rate card debt with lower-rate debt.

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When is a home equity loan better than a mortgage?

Refinancing your mortgage can also give you access to home equity if you use a cash-out refinance. But there are still several ways in which a home equity loan is better than refinancing.

First of all, home equity loans tend to have less onerous requirements than a full-blown mortgage. Especially if you get a home equity loan through your existing mortgage-lender, you can often skip some of the formalities involved in getting a mortgage loan. In addition to reducing the amount of paperwork and other effort in getting money out of your home, home equity loans can also result in lower closing costs than a mortgage refinancing.

In addition, you can sometimes get better interest rates on a home equity loan than you'd get from refinancing your mortgage. Typically, because home equity lenders are second in line to mortgage lenders, banks charge slightly higher rates on home equity loans. But the availability of variable-rate lines of credit, as well as a variety of teaser rates that many lenders offer, can sometimes push the balance toward home equity loans -- especially when you consider up-front costs.

As a homeowner, it's important to know all the ways you can tap your home equity when you need it. Knowing what a home equity loan is and when you should use it can be a financial lifesaver when you need access to the money that's locked up in your home.

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