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A home equity loan is simply where you’re taking a second mortgage against your house. So, I know that might sound a little confusing, but let me give you an example.
Let’s say my house is worth 0,000, and I have a mortgage on it, and I owe 0,000 on that mortgage. So, that means there’s 0,000 of equity there in that property. And one of the challenges, sometime, is you pay your mortgage down, you might want to use that equity or some of that value, for other financial goals you’re looking to achieve. So, how do you do that?
The way you do that, is by taking out a home equity loan against the property. And most home equity loans might be a 10 or 20 year loan, and you’re borrowing the money. And typically you’re gonna pay a little higher interest rate than you would on your regular mortgage, because, technically, if you don’t make your payments, the bank that holds the first mortgage has the first right to your collateral. And the lender for the second mortgage, or the home equity loan, would be next in line. So because of that, there’s a little bit more risk, and you’ll often be assessed a little bit more interest, because of that risk.
Now, there are two main types of home equity loans. There’s a set loan, a home equity loan where I borrow a certain amount. Let’s say, I borrow ,000. I pay interest on it, and every month I make my monthly payment. So, I know exactly when I’ll be done, and I know exactly what my monthly payment will be. That’s known in the industry as a home equity loan.
Another type of home equity, is what’s called a home equity line of credit. This is where you have access to money, but you’re only gonna pay interest, if you actually use it. So, it works very similar to a credit card where, if I’m not using the money, I’m typically not paying interest. But once I use it, then there’s a balance, and a monthly payment associated with it.
So, really important, a lot of times people take credit card debt, or other types of debt, and they want to consolidate it onto a home equity loan. And the reason they want to do that is, number one, to simplify their financial life. Number two, home equity loans usually have a lower interest rate, than credit cards, for example. And number three, sometimes the interest on a home equity loan is tax deductible. So, those are all good benefits.
But if you do this, be aware that once you do that, you’re home is now at risk. In other words, if I can’t make my credit card payments, the lender can’t come take my house. But if I can’t make my home equity loan payments, my house now is at risk. So, that’s a big difference.
Number two, most home equity loans take a lot of time. They’re 10, 20 year loans. And, like we were talking about, if you stretch out debt, often times you may pay more over the long term, even though your monthly payment may go down.
And lastly, when consolidating debt onto a home equity loan, be aware that you’re not moving debt around versus paying it off. Because I see a lot of people, they move credit card debt to their home equity loan, and then in a few years, what happens? The credit card debt starts coming back, and they owe money on the home equity. So, they have more debt. They’re addressing some of the symptoms, and not the cause.
So, home equity loans can be a great way to give you access to money and equity that’s tied up in your property. But just make sure you don’t fall into any of those problem areas, because I see that happen a lot. And people underestimate the risk that they incur.
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Simple example of borrowing from equity to fuel consumption. Created by Sal Khan.
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Finance and capital markets on Khan Academy: This old and badly drawn tutorial covers a topic essential to anyone planning to not live in the woods — your personal balance sheet. Since homes are usually the biggest part of these personal balance sheets, we cover that too.
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