How do home equity loans work?

Answer 1

Answer

A home equity loan is a way of cashing out your investment in your house.

Basically you're borrowing against your investment -- your equity-- in your home. Example: Suppose you bought your house ten years ago for $100,000. Today, it's worth $120,000. You have paid off $20,000 in principle. So, your current mortgage is for $80,000 and your home is worth $120,000. A home equity loan would allow you to borrow $20,000 - $40,000.

Be aware that many, many people are using home equity loans to finance elaborate vacations or spending sprees, which most financial advisors discourage. Such a move usually reduces your net worth to zero -- or below. That's money you will have to pay back, usually before you retire.

Home equity loans may be a wise choice if a)you use them to finance education, b)you use them to pay off high-interest credit card debt or c) you invest the money in an asset that returns more than real estate.

For most people, whose home is their single largest investment and who need to pay it off to retire -- home equity loans are not great ideas.

A home-equity loan, also known as a second mortgage, lets homeowners borrow money by leveraging the equity in their homes. Home-equity loans exploded in popularity in 1996 as they provided a way for consumers to somewhat circumvent that year's tax changes, which eliminated deductions for the interest on most consumer purchases.