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Home Equity Loans: Great Benefits, Serious Risks

A loan secured by a homeowner's "equity" can be an economical way of borrowing money because the interest rate is typically low and, for many people, the interest paid will be tax deductible. (Generally, the equity is the current appraised value of a home minus what is owed on the mortgage. If your home is worth $250,000 but you owe $200,000 on your mortgage, your equity is $50,000.) However, there's a big risk: As with any mortgage loan, if you can't make your payments, you can lose your home. That's why our first tip is to consider a home equity product as a last resort. You should explore all other borrowing options first.

"If a home equity product is not repaid, a creditor likely can foreclose on the home — to sell the property to pay off what is owed," explained C. Lee Page, an FDIC Consumer Affairs Specialist. "And if the home cannot be sold for enough to pay the debt, the borrower will be responsible for making up the difference. For these reasons, consumers may wish to research other funding sources, perhaps with the help of a banker, financial planner or another advisor."

Given the risks, it's also best to limit your use of a home equity product to necessities. "Home improvements that enhance the value of your property are probably the best use of a home equity product," according to Glenn Gimble, an FDIC Senior Policy Analyst. "But don't risk your home by using the equity to pay for non-necessities, such as a vacation or a new TV," Gimble said.

There are two basic types of home equity products. One is a home equity line of credit, which allows homeowners to borrow up to a maximum amount, usually at a variable interest rate. The other option is a traditional "second mortgage," which is a one-time home equity loan for a lump sum, typically with a fixed monthly payment.

For additional information about both products, see the Federal Reserve Board's brochure What You Should Know about Home Equity Lines of Credit.

Last Updated 6/12/2014