What Are The Pros And Cons Of Home Equity Loans?

As you pay down your mortgage, you build equity in your home that you can borrow. There are pros and cons to taking out a home equity loan, and it’s important to understand both sides before you borrow your equity.

Key Takeaways:

What Are Home Equity Loans?

A home equity loan allows you to borrow cash using the equity in your home as collateral. Equity is the amount of the home you actually own. You can estimate your equity by subtracting what you own on your home from its current market value.

Lenders typically allow you to borrow up to 75% to 85% of the equity you have in your home. The amount you can borrow with a home equity loan will depend on the lender and your payment history. The interest rate you’re offered will depend on your credit score and payment history.

You receive the proceeds from a home equity loan as a lump sum. You typically repay the loan at a fixed interest rate over anywhere from five to 30 years. If you default on the loan, you could lose your home.

What Are The Advantages Of A Home Equity Loan?

A home equity loan is an affordable way to borrow sometimes quite a lot of cash that you can use for anything you wish. Most borrowers use it to achieve long-term financial goals, such as paying for an education, consolidating debt, or renovating your home to increase its value. Let’s look at some of the other advantages of home equity loans.

Lower Interest Rates

Home equity loans typically have lower interest rates than credit cards or other unsecured loans because they use your home as collateral. This reduces the lender’s risk, which allows them to offer a lower interest rate. Unsecured debts generally charge a higher interest rate because the lender has less recourse to recover its losses in case of default.

Fixed Interest

Home equity loans usually have a fixed interest rate. This means your interest rate is set when you take out the loan and doesn’t change. You know exactly how much you will pay in interest and the overall cost of the loan. If interest rates increase in the future, your interest rate will still stay the same.

Predictable Payments

A fixed interest rate means your monthly loan payment won’t change. If interest rates increase, your home equity loan payment won’t change. A predictable monthly payment helps you manage your debts and budget for the long term.

Higher Borrowing Potential

If you have a lot of equity, you can borrow most of it with a home equity loan. Say your lender lets you borrow up to 85% of your home’s current equity, your home is worth $450,000, and you owe $50,000 on your mortgage. That leaves you with $400,000 in equity, and you could borrow as much as $340,000.

Lump-Sum Payment

When you take out a home equity loan, you receive the proceeds as a lump sum. That can be helpful if you’re facing a financial emergency and need cash to pay medical bills or for an expensive home renovation. A lump sum also can come in handy if you want to consolidate a lot of high-interest debt.

Possible Deductible Interest

If you take out a home equity loan during the tax years 2018 through 2025, the interest you pay may be tax deductible. To do so, you must have used the loan to increase the value of your home – such as covering the cost of renovations. If you took out a home equity loan during this time, you cannot deduct interest if you used the money for personal living expenses or to consolidate credit card debt. If you took out a home equity loan before 2018, the interest may still be deductible.

Are There Downsides To A Home Equity Loan?

It’s important to know the risks of taking out a home equity loan.

Risk Of Foreclosure

Because your home is collateral for your home equity loan, you risk foreclosure if you stop making loan payments. If you default, the lender can seize your property and sell it at auction to cover their losses.

Harder To Qualify

To get a home equity loan, you’ll first need enough equity to borrow. Lenders typically require that you have at least 15% to 20% equity before you can borrow it. You’ll also need to meet the lender’s eligibility requirements regarding a minimum credit score and maximum debt-to-income ratio. Lenders typically require a credit score of at least 660 for a home equity loan. If your credit score is less than 700, you’ll likely have to pay a higher interest rate.

Another Monthly Payment

A home equity loan is a second mortgage, which means you’ll need to make that payment each month in addition to your primary mortgage payment. It’s important to consider what that means for your budget. Be sure you can afford both payments because, if you can’t, you could lose your home.

Longer Approval Time

Taking out a home equity loan isn’t as complicated as buying a home. However, it can take longer to apply, be approved for, and receive your loan compared with other types. In general, you can expect the entire process to take anywhere from two weeks to two months.

Closing Costs And Fees

Like when you got your primary mortgage, you’ll need to pay closing costs on a home equity loan. Expect closing costs to total 2% to 5% of the loan amount. If you’re taking out an $80,000 loan, your closing costs should be between $1,600 and $4,000.

Risk Of Being Underwater

Even if you don’t lose your home, you could end up underwater on your mortgage. That means you owe more on your home than it’s worth. This can occur if property values drop significantly in your area. For example, if you owe $100,000 on your mortgage and took out a $100,000 home equity loan, you’d be underwater if the value of your home dropped below $200,000.

What Are Some Alternatives To Home Equity Loans?

If you need to borrow cash, a home equity loan isn’t your only option. Here are some alternatives.

Home Equity Loan Vs. HELOC

A home equity line of credit is like a home equity loan in that it lets you borrow your equity using your home as collateral. The difference is that a HELOC is an open-ended line of credit that you can borrow against as needed up to a maximum amount.

A HELOC is helpful if you’re unsure exactly how much you’ll need to borrow or if you plan to tackle several smaller projects instead of a single large one. Another key difference is that home equity loans typically have fixed interest rates, while HELOCs have adjustable rates.

Home Equity Loan Vs. Cash-Out Refinance

A cash-out refinance is when you take out a new mortgage based on your home’s current value, pay off your current mortgage, and keep the difference as cash. For example, if you need $100,000 to pay for college, you can take out a new mortgage based on your home’s current value of $400,000 and pay off your current mortgage’s balance of $200,000. Your lender will require you to keep 20% equity in your home, which is $80,000, and you receive the remaining $120,000 you borrowed as cash to do with as you please. You repay the money you borrowed as part of your new mortgage. Unlike a home equity loan or a HELOC, a cash-out refinance isn’t a second mortgage, so you’ll still only have one monthly payment.

Home Equity Loan Vs. Personal Loan

Personal loans require no collateral. That means you don’t need a minimum amount of equity, and there’s no risk of losing your home. However, personal loans typically come with higher interest rates. Home equity loans can be a better option if you want to borrow a larger amount and your credit isn’t so great.

FAQ

Here are answers to some common questions about the pros and cons of home equity loans.

The Bottom Line

Home equity loans are a useful way to borrow your equity and pay for a large expense. This type of loan comes as a lump sum with a fixed interest rate often lower than other types. However, since you’re using your home as collateral, you risk foreclosure if you fail to repay it.

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