Home Equity Loan

What It Means

A home equity loan is a loan that is available to homeowners. In the most basic sense a loan is a sum of money that is borrowed by a person or company and then repaid, with interest (a percentage of the loan amount, usually calculated on an annual basis), over a set period of time. Two principal parties are involved in loan transactions: a borrower (the party borrowing the money) and a lender (the party lending the money). The two basic types of loans are secured and unsecured. In obtaining a secured loan the borrower presents the lender with some piece of property (for example, an automobile), of which the lender can claim ownership in the event the borrower fails to repay the loan (also known as defaulting on a loan). This property is known as collateral. Unsecured loans, on the other hand, do not require the borrower to have collateral. A home equity loan is a form of secured loan, in that the borrower uses his or her house as collateral to secure the loan. People take out home equity loans for various purposes, such as undertaking home improvements or paying off debt (something—for example, money, a piece of property, or a service—that an individual owes to another individual or an entity).

In almost all cases a home equity loan will represent the second loan a borrower secures using his or her house as collateral. Because houses are very expensive, most homebuyers must first take out a loan to purchase a house. These home loans (commonly known as mortgages) are for large amounts of money and are repaid in monthly installments over a long period of time, typically 30 years. As time passes the value of the home will usually increase (a process known as appreciation), while the total of the mortgage that remains to be paid gradually decreases. The difference between the value of the house and the amount remaining on the mortgage is known as equity. Put another way equity represents the amount of money a homeowner is able to retain after he or she sells the home and pays off the remainder of the mortgage. For example, say a couple purchases a home for $200,000. They pay $20,000 up front (known as a down payment) and then take out a loan for the remaining $180,000. On the day they complete the purchase of the house (also known as the closing), the couple has $20,000 in equity (in other words the original down payment). Two years later their house is valued at $220,000, and the amount remaining on their mortgage is $176,000. In this scenario the couple would have $44,000 in equity on their home. With home equity loans the amount of money a homeowner can borrow depends on the amount of equity he or she has in the house. Traditionally this type of home loan is referred to as a second mortgage.

When Did It Begin

In certain respects the modern home equity loan dates to the Great Depression. The Great Depression, or simply Depression, was a period of severe worldwide economic hardship dating from 1929 to about 1939. In the early years of the Depression, a large number of American property owners, many of them farmers, were in danger of losing their properties because they were unable to keep up with their monthly mortgage payments. In order to provide property owners relief from the burden of their mortgage payments, lenders began to offer them additional loans, or second mortgages. As with the original mortgage these additional property loans were secured loans, using the borrower’s house or farm as collateral. While these loans did provide temporary financial relief to some property owners, in most cases they merely plunged the borrower deeper in debt; unable to pay off their debts, many American homeowners and farmers lost their properties, which were subsequently sold by the lender (a process known as foreclosure). Because second mortgages were usually associated with poverty, they were often considered a source of social stigma for much of the twentieth century.

Home equity loans became more common during the 1980s, following the passage of the Tax Reform Act of 1986. Under the Tax Reform Act interest on standard consumer loans was no longer tax deductible. In other words consumers could no longer deduct their interest payments from their taxable income, meaning their tax payments were higher. Home loans, on the other hand, were considered exempt from these new restrictions. This exemption included second mortgages. As more borrowers began to recognize the economic advantages of securing a home equity loan, rather than a loan that was not tax deductible, the home equity loan business began to thrive. In many cases consumers used home equity loans to pay off their existing, nondeductible loans, a process known as debt consolidation.

More Detailed Information

The two basic types of home equity loans are closed end and open end. A closed-end home equity loan involves a fixed amount of money; the borrower receives the entire amount of the loan (known as a lump sum) upon completing the loan agreement process (or closing). Closed-end home equity loans usually have fixed interest rates (in other words the interest rate remains the same for the life of the loan). Typically the amount of the loan will depend on the amount of equity the borrower has in his or her house; the loan amount might also depend to some degree on the borrower’s credit rating (in other words whether he or she has a proven record of paying off debts in a timely manner). In most cases a borrower is able to borrow up to 100 percent of the equity he or she has in a house. When economists talk about second mortgages they are typically referring to closed-end home equity loans.

With open-end home equity loans, on the other hand, the borrower does not take the lump sum of the loan amount all at once. Instead the borrower receives the loan as credit (that is, as a maximum amount of money he or she can borrow), which the borrower can use as desired. This type of home equity loan is commonly referred to as a home equity line of credit (HELOC). The borrower can take money out of a HELOC at any time and is only required to pay back the amount he or she actually uses. A HELOC is subject to what is known as a draw period, during which the borrower is entitled to borrow money, up to the total amount of the loan, whenever he or she wants. In this way open-end home equity loans give the borrower a greater amount of flexibility. Most open-end home equity loans have variable, or adjustable, interest rates. These rates tend to change over the life of the loan.

Recent Trends

Through the late 1990s most people seeking home equity loans took out closed-end loans, or second mortgages, rather than open-end loans. In the early years of the twenty-first century, however, this trend changed dramatically, as more people began to use their equity to take out HELOCs. For example, in the year 2000, American banks generated more than $163 billion in traditional closed-end home equity loans versus just over $133 billion in HELOCs. During the first half of 2004 the total amount of closed-end loans generated by banks was $88 billion, reflecting a moderate rise; during the same period banks generated more than $356 billion in HELOCs, more than a 250 percent increase compared to the year 2000.