Pros and Cons of a Home Equity Loan
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Summary:
There are multiple pros and cons to a home equity loan, which can be a great way to tap into the equity you’ve built up in your home. Many people use their home equity loan proceeds for worthwhile purposes such as home improvements or to consolidate high-interest debt. It’s also typically a less expensive option than an unsecured personal loan because of lower interest rates. But there are also downsides to home equity loans, so it’s important for homeowners to be aware of both the advantages and disadvantages of this type of loan product.
Since 2021, home prices have soared due to the laws of supply and demand: There are too many buyers and not enough houses to sell. This means homeowners are now seeing drastic increases in their home equity, making it seem like an excellent time to use that cash.
But before you run to the bank to borrow money, let’s take a closer look at the pros and cons of a home equity loan to see if this is the best option for you. We’ll also discuss some other alternatives to accessing your home’s equity. First, a quick recap of exactly what a home equity loan entails.
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What is a home equity loan?
A home equity loan is a second mortgage on your house. You borrow a lump sum of cash at a fixed interest rate using your home as collateral for the loan amount. Because the loan comes with a fixed interest rate, that means you will have predictable monthly payments throughout the repayment period.
If you have a good credit score, you can usually borrow up to 80% or 90% of the equity in your home. Home equity loan repayment terms usually run anywhere from five to 30 years.
IMPORTANT! Keep in mind that you need to have enough equity in your home before you apply for a home equity loan. If you don’t have sufficient equity in your home — typically lenders require at least 20% — you may not qualify for a home equity loan at all.
Pros and cons of home equity loans
As with most financial transactions, home equity loans have risks and rewards that homeowners should be aware of before deciding if this is the best way to borrow money against the equity in their house.
The bottom line: Home equity loans can be a great way to access cash for large purchases, but there are also significant risks to borrowing money and using your house as collateral. Also keep in mind that you’ll need a good credit history for loan approval, and how much you can borrow depends on how much equity you have in the home.
Pros of home equity loans explained
- Lower interest rates. A home equity loan is a secured loan because you’re using your house as collateral. This means you can usually get better interest rates than with other lending options, such as unsecured personal loans.
- Fixed interest rates. Because a home equity loan has a fixed interest rate for the life of the loan, you don’t have to worry about your interest rate going up. This is true even if the Federal Reserve raises interest rates.
- Equal monthly payments. It’s easier to manage your budget when you have fixed monthly payments to deal with. For example, a home equity line of credit (HELOC) —another way to tap into your established equity — comes with a variable interest rate. This means your monthly payment can go up or down depending on the interest rates.
- Can be easier to qualify for. While you still need a pretty good credit score to qualify for a home equity loan — most lenders prefer a minimum credit score of 620 — it can be easier to get a home equity loan than an unsecured loan. And, of course, the better your credit history, the more favorable your interest rate and loan term will be.
- Interest may be tax deductible. If borrowers use the home equity loan proceeds to “buy, build or substantially improve their main home or second home,” the IRS will allow homeowners to deduct the interest paid on the home equity loan on their taxes.
- Can use the money for anything. A home equity loan is a lump sum of cash that borrowers can use for basically any purpose. Home improvements and debt consolidation are two common uses, but others might use the money for higher education, to buy a rental property, or to invest in their business.
Cons of a home equity loan explained
- Loan secured by your home. This is perhaps the biggest drawback of a home equity loan. When you use your house as collateral for a loan, you run the risk of foreclosure if you miss payments.
- Two monthly payments. Because a home equity loan is a second mortgage, your monthly budget now must accommodate two mortgage payments. This could be a struggle for some borrowers.
- Fixed interest rates. Yes, this is both a pro and a con of a home equity loan. Even if mortgage rates go down drastically, you’re still locked into the interest rate you were given at the origination of your home equity loan.
- Higher interest rate than primary mortgage. A home equity loan is riskier for lenders because, if you do default, they fall in line behind the lender of the primary mortgage to get paid back. For this reason, you’ll usually pay a higher interest rate for a home equity loan than you did on your first mortgage.
- Closing costs. While this may not be true of every lender, you may have to pay closing costs on home equity loans, which can significantly add to the cost of the loan. If you do have to cover closing costs, they usually come to between 2% and 5% of the loan amount.
- May cause unnecessary spending. Just because you can borrow $100,000 doesn’t mean you should. Taking out money to fix up your house and increase its value is one thing, but using the cash to buy a fancy new car (that will only depreciate) isn’t a responsible reason to take out another mortgage.
- Risk of home losing value. Your home’s equity is fluid, so just because you have $100,000 in equity today doesn’t mean you still will in six months. Borrowing too much of your home equity can result in being underwater on your mortgage, meaning you owe more than the house is worth. If you want or need to sell the home, you could end up losing money in the deal.
Even with these pros and cons in mind, a home equity loan might be the best financing option for you. To get a better idea of the rates and loan terms you qualify for, take a look at some of the home equity loan lenders below.
Alternatives to home equity loans
After weighing the pros and cons of a home equity loan, you may want to explore some other options to access the equity in your home.
Cash-out refinance
A cash-out refinance replaces your existing mortgage with a new mortgage and “cashes out” the home equity as a lump sum payment to you. This is an attractive option if you want only one mortgage payment.
However, you’ll likely have a higher interest rate than your current mortgage and because a cash-out refinance is an entirely new mortgage, you will have to pay closing costs. You’ll probably also need a good or even excellent credit score to qualify for this home loan.
Home equity line of credit
A home equity line of credit (HELOC) is similar to a home equity loan but works more like a credit card. The nice thing about HELOCs is that you are given a credit line rather than a lump sum of cash like with home equity loans. This means you can borrow as much or as little as you like during the draw period.
The draw period is typically 10 years, and during this time you need only pay interest payments. That said, you can always pay more when you have extra cash. HELOCs also differ from home equity loans in that they come with variable interest rates.
This can be a pro or a con depending on what the Federal Reserve is doing with interest rates. Though you won’t have predictable monthly payments, you can take advantage of a lower interest rate if rates go down during the repayment periods.
Home equity investments
If you’re looking to pull some equity out of your home without worrying about interest rates and a new monthly payment, you might want to consider a home equity investment, also known as a shared equity agreement. This is an arrangement where an investment company gives you cash in exchange for a share in the future equity of your home.
You won’t have to pay the money back until you sell your home or the contract is up. At that point, you pay back the money plus a percentage of the house’s current equity. Shared equity agreements typically have less stringent credit requirements, so even those with poor credit may qualify.
Pro Tip
If you know exactly how much money you need for a specific project, consider a home equity loan or cash-out refinance. If you’d like to have a line of credit on hand for emergencies or various home improvement projects, a home equity line of credit might be a better option for you.
Other options
If using your house’s equity isn’t the right choice for you, here are a couple more possibilities if you need some extra cash.
Personal loans
Pulling equity out of your home can take time to get through the application process, but a personal loan can be a faster option. You may pay interest at a higher fixed rate, but if you’re looking for a loan product with a quicker turnaround and a shorter loan term, a personal loan might be right for you.
Credit cards
You don’t always want to reach for a high-interest credit card to solve your every need, but they can be great in a pinch. If you don’t need a large sum of money and you plan on paying the balance off quickly, sometimes a credit card is your best choice.
If you need to make a large payment quickly, you can apply for a credit card with a 0% introductory rate. This means you could have an interest-free loan anywhere from six months to two years.
FAQs
Does a home equity loan hurt your credit?
Anytime there’s a hard inquiry into your credit, it will cause a temporary drop in your credit score. Plus, adding new credit can also cause a hit to your score. But these are temporary dips, and your score should bounce back within a year or less, assuming you manage the new debt responsibly.
In some cases, a home equity loan can even improve your credit. For example, if you use the loan to pay off your high-interest debt, you could see your score improve instead.
Can you get a home equity loan without a mortgage?
If you own your home and have paid off your mortgage, congratulations! You have 100% equity in your home and will almost certainly qualify for a home equity loan. Though you still need to have good credit, the fact that you don’t have an existing mortgage should mean you qualify for a lower interest rate and excellent repayment terms.
Key Takeaways
- Home equity loans are a great way to make use of the equity in your home and can be cheaper than other loans such as unsecured personal loans.
- Risks of home equity loans include putting your house up as collateral and having to pay two mortgage payments every month.
- Alternatives to home equity loans include cash-out refinancing, home equity lines of credit, and shared equity agreements.
- Other borrowing options are credit cards with a 0% APR introductory offer and personal loans.
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