When you get a home equity loan, you're borrowing against your ownership percentage in your home that is free of other liens, such as a first mortgage. While a home equity loan is often tempting, since it provides you with a sum of cash you can use however you want, it does come with some risky downsides. As with any loan, always consider the specific offer terms, including fees and any penalties for paying it off early.
Risk of Foreclosure
You're at risk of losing your home if you can't make the home equity loan payments. It differs considerably from a personal loan because the lender receives a form of interest in your home when you take out the home equity mortgage. If you default, the lender can start the foreclosure process against you, which likely will end with a public auction of your home to the highest bidder.
Lower Rates and Free Use
A home equity loan usually carries a lower interest than a personal loan because the loan is secured by property. You can use the cash to pay down other debt or to fund a goal, such as your child's college tuition. Since the lender can go after your house if you stop paying, you're viewed as less of a risk than a person with a loan that isn't secured by any property. Because the home is an item of value that the lender can seize and sell to cover some of its loss from the loan, the lower perceived risk translates into a lower interest rate for you.
You may end up "underwater" on a home equity loan, especially if your loan was for all of your home's equity at the time you took it out. Property values may decline in your area for a variety of reasons, such as increasing crime rates or a poor local housing market. You're underwater if you end up owing more on your loan than your home is actually worth. Being underwater can make it very hard to sell if you can't make the payments or need to move.
When paying income taxes, you can deduct all or part of the interest you pay on your home equity loan, but only if you itemize. The home mortgage interest deduction applies to home equity loans, and applies to loans on second homes as well as your primary residence. Whether you can deduct all or just some of the interest you paid depends on your balance totals, when you took your loan out, and what the proceeds were used for in some cases. According to the Internal Revenue Service, most people can deduct all the mortgage interest they paid during the tax year.
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