When you buy a home, you’re making an investment. With each payment, you’re building equity, which you’ll then retain when you sell the home. You can take out a loan based on that equity, but a home equity loan can be risky because the lender can foreclose if you don’t make your payments.
If you are unable to make the payments on your home equity loan and default, your lender may choose to foreclose on your property.
Home Equity Loan Purpose
Homeownership is expensive. Not only do you have to pay for upkeep expenses like landscaping and repairs, but if you want to do any major upgrades, you’ll probably find you need tens of thousands of dollars.
A home equity loan will give you the capital you need without putting your house on the market. Everything will be done directly through a lender, with no real estate agent necessary. This type of loan uses the equity in your home as collateral for the amount you’re taking out, but there can be risks tied up in these types of loans.
Home Equity Loans and Credit
When you initially take out your home equity loan, you’ll see a drop in your credit score. One study from LendingTree found that scores dropped, on average, 13 points following a new home equity loan, taking around five months to reach their lowest point. Following that drop, your credit will begin to recover, though, reaching your original score within one year of your home equity loan.
But your credit score will only improve if you make your loan payments on time each month. Even worse, if you miss payments on a home equity loan you can lose your house since the lender can foreclose to recoup its investment. This makes a home equity loan a bigger risk than loans where your home isn’t used as collateral.
Types of Home Equity Loans
Before you visit your lender, you’ll need to decide the type of loan you want, since there are two types of home equity loans. This doesn’t change the fact that if you miss payments on a home equity loan you can lose your home, but it’s still important to note. Here are the two types of home equity loans:
- Fixed-rate loans: With this type of loan, you get a lump sum from the lender, with an agreement that you’ll pay back the amount in fixed installments over a period of time. You’ll have a fixed interest rate.
- Home equity line of credit: A line of credit does not issue one big payout at the time of the loan. Instead, you’re given a fixed spending limit, similar to what you get with a credit card. Your interest rate can vary over the term of the loan and you can use the funds as you need them, as long as you make the required monthly payments.
Terms of Home Equity Loans
Your home equity loan likely won’t have the same terms as your mortgage, so it’s important to pay close attention to the fine print. You may assume that your home equity loan has the same grace period as your mortgage, for instance, and end up with late fees and credit damage due to mailing your payments in late.
Another thing to note when you’re taking out a home equity loan is how the interest will be calculated. Your original home loan is probably a traditional loan, while home equity loans can be simple-interest loans. This type of loan calculates interest each day, whereas interest is calculated by the month on a traditional loan. If so, your interest will be slightly higher with your home equity loan since the interest rate is divided by 365 days, with that number multiplied by the amount you have left on your loan.
Advantages of Home Equity Loans
The biggest benefit of a home equity loan is that it provides a source of funding if you need extra money. Generally, you’ll get a much lower interest rate than you’d get through other types of loans because of the collateral your home’s equity provides. You can use it to pay off loans that have much higher interest rates and save some money, making these loans popular for debt consolidation.
The interest on home equity loans can also be deducted on your taxes, although the Tax Cuts and Jobs Act has limited that slightly. Under the changes, you can only deduct interest on a loan if the money was put toward making major renovations to your home. In other words, you can no longer claim the interest you paid on a home equity loan used to pay off debts or buy other items. You can also deduct interest only on loans of up to $375,000, or $750,000 if you’re married filing jointly.
Disadvantages of Home Equity Loans
As with any type of borrowing, home equity loans can be a slippery slope for consumers. In the industry, experts use a term called reloading to describe borrowers who take out loans to pay off debt so that they can free up enough credit to make additional purchases, putting themselves further and further in debt. Over time, those same borrowers could find themselves in a position where they can’t afford the monthly payments on all the debt they’ve racked up.
Unlike other types of loans, though, a home equity loan can be risky because the lender can foreclose if you don’t make your payments. It’s one thing to put your credit score at risk, but you likely don’t want to lose your home. Even if you’re certain you can make the payments today, make sure you could cover it if you lost your job or had unexpected medical bills.
Second Mortgage Versus Home Equity
You may also have heard the term second mortgage, thinking it’s something different. In fact, a second mortgage and home equity loan refer to the same thing: a loan against the equity in your primary home. Since it’s important to distinguish between a home equity loan and a home equity line of credit, generally you’ll see the term home equity loan more often than second mortgage.
Another reason you may not see the term “second mortgage on your home” as often as home equity loan is that it can easily be confused with a mortgage for a second home. This type of second mortgage is a completely separate mortgage from the one on your primary residence, generally used to pay for a vacation home or investment property.
How Property Liens Work
Although your biggest concern is likely if you miss payments on a home equity loan, you can lose your house, it’s usually not that straightforward. A home equity loan is a junior lien, which places a hold on your property until it’s paid. However, junior liens are secondary to senior liens, which refer to the first mortgage on the house.
If you can’t pay any of your bills and your home goes into foreclosure, the court will order that your first lien – the mortgage – be paid before any junior liens on the property can be tackled. Property tax liens are given automatic superiority over all other liens, so if you aren’t paying those, your home will be sold and property taxes paid, then your home mortgage, then junior liens like home equity loans.
Defaulting on Second Mortgage Only
If you decide to stop paying your home equity loan while still paying property tax and your first mortgage, the lender on that loan can still foreclose on your home. Whether it chooses to do so depends on the value of your home. You secured the loan based on the actual equity you have in your home, so the lender can recoup its money by foreclosing on your home, selling it and using the proceeds, but this only works if the bank can sell the home and use the proceeds to pay off that first loan as well as the second
In a tough housing market, homeowners often find the value in their homes drops so much, they owe more than what they’d get in a sale. In that situation, a home is considered underwater. If the lender on that second mortgage can’t sell the home and get back what you owe, foreclosing wouldn’t be in that lender’s best interest.
Recourse Versus Non-Recourse Loans
A home equity loan can be risky because the lender can foreclose if you don’t make your payments. However, in some states, the lender can not only take your home but continue to come after you if that home sale isn’t sufficient. There are two types of loans:
- Recourse loan: With this type of loan, a lender can take the asset used to secure your loan, as well as other assets as necessary, including wage garnishment.
- Nonrecourse loan: This type of loan limits what a lender can collect to the asset that was used to secure it. If the home seizure doesn’t pay back the lender, the lender is out of luck.
The law on recourse loans varies from one state to the next. If you live in the following states, nonrecourse loans are the only option: Alaska, Arizona, California, Connecticut, Florida, Idaho, Minnesota, North Carolina, North Dakota, Texas, Utah and Washington. But you, as a borrower, have control over the terms of your loan. Search specifically for a nonrecourse loan if you’re concerned about limiting your own liability in the event of a default.
Consequences of Foreclosure
If the worst happens and your first or second mortgage lender opts to take your home, it’s important to know the consequences. If you walk away from your loan and you have a recourse loan, your lender could do more than just seize your home. You could end up with something called a deficiency judgment, which allows the lender to garnish your wages or levy your bank account for the funds.
In addition to losing your home and the equity you have in it, a foreclosure could have the following repercussions:
- Your foreclosure will show up on your credit report, which means you’ll have trouble getting a home loan for up to seven years.
- If you lose your home, you’ll need a place to live. Even landlords check credit reports on lenders, and you may be denied unless you can get into a rental before the foreclosure hits your credit report. Even then, you’ll be stuck there for a while.
- Some employers also run credit checks, so a foreclosure could hurt your future job prospects.
Alternatives to Foreclosure
When you see financial difficulties ahead, one of the best things you can do is contact your creditors and let them know the situation. They’ll likely want to work out a lower minimum monthly payment to avoid losing their money. If your issue is temporary, some lenders will let you skip a payment or two, tacking the extra onto the end of your term.
One of the best options if you’re in hot financial water is to look into refinancing some or all of your debts. This could mean refinancing your first mortgage, your second mortgage or one of your other loans. You’ll find this option especially attractive if interest rates have dropped significantly. If you can lower your monthly payment on at least one of your loans, you may be able to better stay on top of your debts.
- Realtor.com: What Do All Those Real Estate Listing Terms Really Mean?
- Home Equity Loans and Credit Lines | FTC Consumer Information
- HousingWire: Do Home Equity Loans Affect Your Credit Score?
- LendingTree: Is Home Equity Loan Interest Tax Deductible?
- U.S. Bank: Second Mortgage vs. Home Equity Loan
- Nolo: What Happens If I Don't Pay My Second Mortgage?
- USLegal: Junior Lien Law and Legal Definition
- Nonrecourse debt - Wikipedia
- Nolo: Avoiding Foreclosure: Basic Workout Options
- Nolo: Strategic Default: Should You Walk Away From Your Home?
- Simple Loan Calculator | Loan Payment Calculator | Firefly
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.