What is a Home Equity Loan?

A home equity loan allows homeowners to access the equity in their primary residence without having to sell the property. Equity is the difference between what a home is worth and what is owed against it. Traditionally, home equity loans were called second and third mortgages.

Equity in a home comes from two sources. Mortgage payments, over a period of time, reduce the amount owed against a property, and real estate appreciation increases the gross value. After several years of making mortgage payments, the equity accrued can be substantial. For example, a home purchased for $250,000 with a zero down payment mortgage and appreciating 5% a year may have $50,000 in equity in as little as five years.

Banks and finance companies often given favorable rates on home equity loans as real estate is perceived to be a very stable investment. This is especially true when the economy isn't struggling, as real estate has a long history of appreciation. Mortgage lenders also have access to quasi-governmental agencies such as the Federal National Mortgage Agency (Fannie Mae) that reduce lending rates by shifting interest risk away from the lender.

While home equity loans have favorable rates relative to auto loans or credit card debt, the rates are still higher than for a first mortgage. A home equity loan can be turned into a first mortgage through a process known as refinancing.

A reverse mortgage is similar to a home equity loan in that it allows access to the cash value of the homeowner's equity. Instead of a lump sum, however, a reverse mortgage pays out in monthly or quarterly payments. Reverse mortgages are targeted at seniors who would like additional income, but don't wish to sell their homes and move. Upon death, the home is either sold by the estate or the title reverts to the lender, who then sells the property themselves.