Pros & Cons of Getting a Second Mortgage or Home Equity Loan
If you've got equity in your home, either because you've paid off some of your mortgage or because your home's value has gone up, you can tap into it with a home equity loan, also called a second mortgage. Though you can use the money for whatever you want, it's not always a wise decision.
Lower Interest Rate
Using your home as collateral for the loan makes it less risky for the lender, which means you'll get a lower interest rate than an unsecured loan. For example, you're going to pay a lower interest rate on a home equity loan than a personal loan and a significantly lower rate than on a credit card balance. If you use a home equity debt to pay off your credit cards, you'll save on interest. Of course, that won't do you any good if you run up the balances on your cards again.
The interest you pay on a home equity loan is tax deductible -- at least in part. As of 2013, you can deduct the interest on the first $100,000 ($50,000 if you're married filing separately) of your home equity loan. If you use the proceeds of your home equity loan for home improvements like a new garage, the limits are higher: the interest on the first $1.1 million ($550,000 if married filing separately) is deductible. However, the deduction only applies if you give up your standard deduction and itemize.
Adjustable Rate Changes
Some home equity loans offer a variable interest rate, with the benefit being that if interest rates fall you get to take advantage of the lower rate without paying to refinance. The downside is that if market rates go up, you're on the hook for the increased interest charges. Though you might be tempted to take an adjustable rate because of the low teaser rate, make sure you budget for higher rates if interest rates go upward.
Risk of Foreclosure
As with any loan secured by your home, taking out a home equity loan puts your house on the line if you're not able to repay the loan. Tapping your home's equity can allow you to rack up debt by living above your means, and it can cost you in the long run, especially if you don't get the raises you expect or worse, lose your job.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."