Home Equity Loans

Dave Kutcher

by Dave Kutcher

The question came across our desk recently as to how a home equity loan works. We will provide some guidance below and would like to add here that financing (debt) can be a useful resource of money, however, it is always very important to manage your expenses and not take on debt service that you potentially cannot keep up with in the future, subjecting yourself to adverse credit ratings or worse, losing your home to foreclosure.

A home equity loan is a type of loan that allows you to borrow money using your home as collateral. The amount that you can borrow is based upon the difference between your home’s current value and the amount you may already owe on your primary mortgage.

As you make mortgage payments each month on your home, reducing the amount of your loan and/or your property’s value increases over time, you are gaining or increasing equity in your home and can exchange that equity for cash through a home equity loan.

When you create a home equity loan you receive a lump sum of cash and you pay it back at a fixed loan interest rate over time, typically a 5–20-year loan term period.

(It is important to point out here that the loan term described above applies to home equity loans, not necessarily home equity “lines of credit”. While the two types of financing are similar, they each carry their own financing terms.)

Additionally, you should remember that securing a home equity loan involves costs and fees that are in addition to any interest expense created by the loan, and you are pledging your home as the collateral basis for the funds you are seeking.

So, how much can I borrow?

As with any financing, your ability to secure funding requires some due diligence work on the part of the lender. Your creditworthiness remains important to secure the best financing rates and a current appraisal on your home will be required.

Most lenders want to see a borrower with at least 20% equity in their home. Some will push this to 10%, but ideally the 20% mark is a good rule of thumb. Maintaining a 20% equity share in your home also eliminates the need for special mortgage insurance coverage that a bank will typically require if this equity requirement is not there.

Your access to home equity falls between the remaining 80% value of your home and the amount of your primary home mortgage.

Let’s walk through an example of how this calculation might work.

In our example, the bank (lender) has determined that the current value on your home is $200,000. Accounting for the 20% equity share the lender wants you to maintain, we would need to subtract $40,000. ($200,000 X 20% = $40,000). This leaves us with $160,000 to work with. We would now need to subtract the existing home mortgage principal balance. In our example, you still owe $100,000 on your primary mortgage. We now subtract $100,000 from the available $160,000 and we have a new available equity balance of $60,000. ($160,000 net equity after the 20% requirement – $100,000 primary mortgage = available new equity of $60,000)

As you are likely aware, your primary home mortgage interest payments are tax deductible. Interest paid on a home equity loan isn’t treated quite that simply.

For tax years 2018 through 2025, if you are using your home equity funds to improve your residence, interest you pay is classified as home acquisition debt and may be deductible subject to certain dollar limits. However, if you use the funds to pay for personal living expenses including refinancing credit card debt, the interest paid on the home equity loan is NOT deductible.

For tax years prior to 2018 and after 2025, personal expenses were/are deductible. ALWAYS remember to check with your tax professional for up to date and correct information for your situation.

The money you receive in the form of the home equity loan is not considered taxable income.

My name is David A. Kutcher, a retired Marine Corp Captain. My business partner in the lower 48 is Richard C. Scott, CLU, LUTCF. For nearly 40 years we have been helping folks with their personal retirement decisions. We encourage you to make an appointment and get ahead of your concerns as early as is possible. You can catch us on the radio every Saturday morning, “Retirement in the Last Frontier”, 8:30-9:30 on AM 650, Keni Radio. Frontier Retirement, 10928 Eagle River Road; Eagle River, AK 99577, (907) 795-7452.