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Using your home as loan collateral.
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Your home might be your castle and your most precious asset, but it also can be a source of funding for anything from building an addition to covering the costs of a wedding.
There are two main ways to tap into the equity built up in your home: a home equity line of credit (HELOC) and a second mortgage (home equity loan). There are some subtle differences between the two (as we’ll see below), but they’re similar in that each uses your home’s equity as collateral.
Key Points
- A HELOC is a credit line—much like a credit card—with variable interest rates, and you only owe what you draw from it.
- With a second mortgage, you’re sent the money upon closing, and payments begin immediately.
- Because the risk to the lender is higher with these two types of “second-lien” loans, interest rates are higher than for a comparable primary or “first-lien” mortgage.
Equity is essentially the balance of outstanding loans on your home, such as the first mortgage, subtracted from the appraised value of the home. (See the sidebar.)
If you decide to tap into your home equity—whichever route you choose—keep in mind you’re taking on more debt. And if you run into financial trouble, you risk losing your home.
Home equity example
Suppose you bought a $400,000 home using a down payment of 20% (or $80,000) and a first mortgage of $320,000. That $80,000 represents your home equity.
(Appraised value) – (outstanding balance) = home equity
$400,000 – $320,000 = $80,000
Suppose after five years, you’ve paid down $40,000 in principal, taking your outstanding balance down to $280,000. Meanwhile, the housing market went up 25%, and your house now appraises for $500,000.
(Appraised value) – (outstanding balance) = home equity
$500,000 – $280,000 = $220,000
HELOC vs. second mortgage
Although both rely on the equity in your home as collateral, there are notable—and potentially costly—differences between the HELOC and the second mortgage.
Home equity line of credit (HELOC). It’s much like a credit card in that you secure a line of credit based on the equity of the home. Borrowers draw on HELOCs when they want to cover an expense—fund a child’s education, pay off credit card debt, take a once-in-a-lifetime vacation—for a specified time period until the repayment period begins. Interest rates are typically of the variable-rate variety. Because HELOCs are secondary to any primary mortgage on the property (what’s called a “second-lien” position), the interest rates are higher than they would be for a comparable first-lien mortgage. However, HELOC rates are usually lower than, say, credit card interest or any other “unsecured” credit.
Most HELOCs carry a 10- to 15-year withdrawal period during which borrowers only make interest payments. The repayment period, which might last as long as 20 years after, requires monthly principal and interest payments that can take an unexpectedly bigger bite out of the budget.
How mortgages work
Want more on down payments, principal, interest, escrow, and other mortgage dynamics? Read our guide.
Second mortgage. Like HELOCs, interest rates on second mortgages tend to be higher than rates on first mortgages, but lower than other loan alternatives. Again, the lender is taking on more risk than they might with a primary mortgage. If the homeowner stumbles into a financial abyss and the home is foreclosed, that original mortgage is first in line to be paid off.
Unlike HELOCs, homeowners get second mortgages in a lump sum. That also means the payback period begins immediately and homeowners will have two monthly mortgage payments until one of them is paid off.
Are interest payments tax deductible?
It depends. Interest rate charges on HELOCs and second mortgages were long considered tax deductions in all cases—even if the loans were used to pay off credit cards or student debt rather than just home improvements or additions. But rules (and overriding strategies) changed with the Tax Cut and Jobs Act of 2017 (TJCA).
The old rules are still in play for what the IRS calls “qualifying years,” meaning before 2018 and after 2025. That is, of course, assuming Congress doesn’t decide to extend the rules beyond 2025.
As it stands, the deductibility of home equity loans—and there’s a new, lower limit (of all mortgages combined) per household of $375,000 for single filers and $750,000 for those married filing jointly—can only be taken on loans used to “buy, build, or substantially improve your home,” according to the IRS.
Itemize vs. standard deduction
Recent tax changes have drastically changed the math. Here’s what you need to know before deciding whether to itemize or take the standard deduction.
In other words, interest on the same loan used to pay personal living expenses, such as credit card debts, would not be deductible. Here’s what else that means: You’ve got to keep meticulous notes and receipts of the work that’s been done should you be asked to prove it—assuming you plan to itemize your deductions.
But, as a reminder, the TCJA also doubled the standard deduction such that, in recent tax years, upwards of 90% of households take the standard deduction.
Don’t lose the house
This is worth repeating: HELOCs and second mortgages are loans against the value of your home. They use the equity in your home as collateral. If you can’t make the payments for whatever reason, your credit score gets smacked and you risk losing your home sweet home in a foreclosure, just the same as if you missed your original mortgage payments. It takes years to repair those kinds of setbacks.
Don’t tap too much into your equity. Although home prices have risen historically, it’s not always in a straight line. For example, in the 2007–08 financial crisis, homes in some regions lost over 40% of their value, causing many homeowners to be “underwater” (meaning they owed more than their home was worth). Nowadays, most lenders won’t let you go below a certain equity threshold. But if you have a second mortgage, a severe downturn could force you into an untenable position.
Remember to close out unused credit lines. An important tip about HELOCs: Don’t forget to close them out after they’re paid off—and get the paperwork to prove it.
Here’s a scenario you don’t want to find yourself in. Suppose you obtain a line of credit for $50,000 against the equity of your home with plans to renovate parts of the house. You finish the job under budget, pay off the balance in short order, and move on.
If you haven’t officially closed out the line of credit, it will just sit there. And if you haven’t secured the paperwork, when you go to sell the home, even 20 years later, that HELOC—again, a loan using the equity of your home as collateral—might still be hanging around with no record of being paid off. When selling a home, there are few things worse than not having a clean title because of some clerical error from many years ago.
The bottom line
HELOCs and second mortgages are two viable vehicles to help you cover some of life’s larger bills. But, in a sense, you’re borrowing money from yourself—equity you’ve worked hard to build. And if you’re relying on that equity to serve you later in life—through a reverse mortgage, or to add to your nest egg if and when you downsize—just remember that tapping into your equity is best when the money is used to further your financial goals.
A bathroom remodel that adds to your home’s appraised value might be a better use of your home equity loan dollars than, say, an exotic trip or a depreciating asset such as a boat. It’s all about good debt versus bad debt.
