What is Home Equity?

The current market value of a home minus the outstanding mortgage balance. Home equity is essentially the amount of ownership that has been built up by the holder of the mortgage through payments and appreciation. Typically, residential property is bought through a mortgage, which is then paid off over a number of years, often 15 or 30. After the mortgage has been fully repaid, the property then belongs to the mortgagor, namely the buyer. In the interim, however, the buyer simply builds up equity in the home. This is what a home equity loan borrows against. Although that equity cannot be sold, banks will lend money against it. Home equity loans offer significant tax savings due to the fact that the interest paid on a home equity loan is tax-deductible. Home equity loans are often used to consolidate other debt with high interest rates (like credit card debt), to finance large expenses (such as college or a wedding), or to purchase other costly items.

There are two main types of home equity loans.

• The traditional home equity loan, also known as the second mortgage, which lends out a lump sum of money that must be repaid over a fixed period.
• The home equity line of credit, which provides the borrower with a checkbook or a credit card that is used to borrow funds against the home equity.

Funds borrowed from a traditional home equity loan start accruing interest immediately after the lump sum is disbursed; funds borrowed from a home equity line of credit do not begin accruing interest until a purchase is made against the equity.

What to expect from home equity loan rates: The rate at which you can borrow against home equity will be higher than the rate for a first mortgage, but lower than for unsecured borrowing, such as a credit card. In case of default, the lender who gave you the first mortgage will be paid off first, and the home equity lender will be paid off second (it's a "second mortgage," remember?), so the home equity lender will charge a higher interest rate because of it is less certain to be repaid.

However, your home equity loan will be substantially lower than money borrowed off a credit card, because the home equity lender can seize your home in case of default, something the credit card lender can't do.