A home equity loan is for all intents and purposes just a mortgage on your home. The lender places a lien on your house, which prevents you from selling it until you pay off the money you owe. You don't have to get the loan fully paid off before you put your home up for sale, but when you do sell, the money you receive had better be enough to pay off the loan, or you've got problems.
Home equity is simply the difference between what your home is worth and what you owe on the mortgage. It's helpful to think of it as the portion of your home's value that you "own." If your house has an appraised value of $250,000, and you've still get $150,000 left on the mortgage, then you have $100,000 worth of equity. People take out home equity loans to convert that equity into cash that they can spend. In doing so, they add to the debt load on their home.
Say you have a house worth $250,000 with $150,000 left on the mortgage, and you take out a $60,000 home equity loan. Since you now have $210,000 borrowed against your house, your home equity has fallen to $40,000. The home equity lender places a lien against your house, and you won't be able to sell it until that lien is satisfied. Since you already have a mortgage, the new lien is a "junior" lien, meaning the home equity lender is second in line to get its money back. The mortgage lender is first in line. If you owned your house free and clear, the home equity loan would essentially be a "first" mortgage, and its lien would be at the front of the line.
Time to Sell
When it comes time to sell your house, your lenders will expect to be satisfied at settlement. Say your house has a $150,000 mortgage and a $60,000 home equity loan, and you sell it for enough money that you net $240,000 after the agents' commissions. The first $150,000 of that pays off the mortgage. The next $60,000 pays off the equity loan. Both lenders remove their liens, you walk away with $30,000, and the new owners take the keys and move in.
When home prices are declining, it's possible to wind up "under water" on your home, meaning you owe more on it than the home is actually worth. This is a special danger for homeowners who have used home equity loans to extract as much money as possible from their homes. Say your situation was the same as described above, but you could only get $200,000 for your home. The mortgage lender get its $150,000 first. Now there's only $50,000 left to satisfy the $60,000 home equity loan. It'll be up to you to come up with the $10,000 difference. If you don't have the money, the equity lender won't lift its lien, and you won't be able to complete the sale of the home.
- The Mortgage Professor: Second Mortgage Versus Home Equity Loan
- Bankrate.com: How Home Equity Loans Work
- Internal Revenue Service. "Home Mortgage Interest Deduction 2016." Page 2. Accessed Aug. 29, 2020.
- Internal Revenue Service. "Publication 5307." Page 5. Accessed Aug. 29, 2020.
- Internal Revenue Service. "Publication 936: Home Mortgage Interest Deduction." Accessed May 12, 2020.
- Internal Revenue Service. "Interest on Home Equity Loans Often Still Deductible Under New Law." Accessed Aug. 29, 2020.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.