If you’ve every heard someone say that they took out a “second mortgage” to pay for something what they were technically referring to is called a home equity loan. Here’s how it works: Very few people can afford to pay cash for a house, so when you find a home you want to buy, a bank will provide a mortgage, loaning you money based on the current value of the home. Equity is the portion of the house that you actually own, which when you first buy your house will be your down payment. As time passes, your equity will likely grow, as your mortgage payments reduce what you owe the bank, and your home value (hopefully) rises. At a certain point, you may decide that you need some cash to finance something like home improvements, higher education for you or your kid, or even the elimination of a big chunk of credit card debt. A bank may agree to loan you money using the equity in your home as collateral. Home equity loans come with fixed interest rates and generally, though not always, must be paid off in a shorter period of time than a mortgage. Depending on the bank, you should expect to be able to borrow a maximum of 70-80% of your total equity.
Accessing this so-called secured credit can feel like a godsend. But there are obvious dangers in tacking on a second monthly payment that absolutely must be made in order for you to keep your house. If you do find yourself in default on a home equity loan, regardless of whether you’re up to date on your primary mortgage, your home equity lender could initiate foreclosure proceedings in order to get its hands on your equity. As was seen in multitudes of cases during the 2008 housing market crash, the more equity you have in a case of default might actually work against you, since banks are less likely to foreclose upon houses that are underwater, or worth less than the money owed on them. In foreclosure sales, the primary mortgage holder always gets paid back first, so if there won’t be anything left over for the home equity lender after a sale, they’re less likely to foreclose.
