Home equity loans, when used properly, can be an incredibly sensible tool for reducing your overall debt payments. Sometimes referred to as smart debt, these loans are second mortgages that allow you to leverage the home equity in your house while still being able to deduct the interest payments on your taxes. In 1996, the U.S. government stopped allowing interest deductibility on funds borrowed for consumer purchases. As a result, banks stepped in to create the home equity line of credit, which allows homeowners to draw upon the increased equity in their homes while at the same time maintaining the tax deductibility they had prior to the changes.
When home prices rise dramatically, as they did from 2000 to 2006, the equity in your home grows without having to make any additional payments. A $75,000 down payment in 2000 on a $300,000 home left you with 25 percent equity in your house. Today, that same home might be worth $450,000. The equity in your home, through price appreciation alone, is now approximately $225,000 or 50 percent of your home's value. Thus, a 50 percent increase in the value of your home results in a 100 percent increase in your home equity without factoring in any principal repayments made up to this point. A winning proposition for sure.
Home equity loans come in two basic forms: the fixed-rate loan and the home equity line of credit, or HELOC for short. As the name implies, the fixed-rate loan charges a fixed rate of interest over a specific number of years with a specific payment. There are no changes in the payment or the interest rate over the entire period of the loan and the borrower receives the full amount in one lump sum payment. In the case of the home equity line of credit, the borrower receives a set spending limit that they can draw upon as necessary. The monthly payment on this type of loan varies depending on the amount outstanding on the loan and the current interest rate. As for the term of the loan, it is usually the same as for a fixed-rate loan.
There are many reasons why someone might consider a home equity line of credit. However, the biggest is the ability to consolidate debt from high-interest unsecured products like credit cards into lower interest, secured products like the HELOC.