What Are the Pros and Cons of a Home Equity Loan?
When you need access to additional cash immediately, you typically have a few options. Borrowing the money is a common one. You can choose to use a credit card or apply for a personal loan to borrow the money, but you might get stuck with a high interest rate or even get denied the loan because the lender doesn’t think you can pay it back. There might be a better option, however: applying for a loan that is secured by collateral.
Putting up something valuable you own as collateral on a loan is reassuring to a lender. Typically, borrowers are more likely to receive the loan they’re looking for—and with more favorable terms—when they provide collateral.
One of the most common assets used as collateral for a loan is the equity someone holds in their home. A home equity loan, as it’s called, is a popular way to get access to funds at good lending rates. However, it’s important to understand home equity loans fully before rushing into one. In this article, we’ll explore the pros and cons of a home equity loan so that you can understand when it might be right for you.
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How Do Home Equity Loans Work?
A home equity loan lets homeowners borrow a sum of money based on the value of their home’s equity. Home equity is the difference between what is owed on the mortgage and the current market value of the property. For example, if your home is valued at $400,000, and you have a mortgage balance of $250,000, your home equity is worth $150,000.
A home equity loan is what’s called a secured loan, which means you receive the loan in exchange for some form of collateral. In this case, the collateral is your home. Compared to unsecured loans, such as credit cards, home equity loans typically have significantly lower interest rates. But this advantage comes with some risks too: If your loan falls into delinquency, you could lose your home.
Let’s break down the pros and cons of a home equity loan.
Pros of a Home Equity Loan
From the point of view of a lender, a secured loan is a great opportunity to offer better terms and conditions, because the borrower will have a strong incentive to pay back what they owe, and if they don’t, you materially benefit. This makes home equity loans a stable, predictable option for both homeowners and lending institutions.
Lower Interest Rates
Lenders view secured loans as inherently less risky, making them more willing to offer competitive rates. So home equity loans typically have much lower interest rates than credit cards. The difference could save the borrower tens of thousands of dollars over the life of the debt.
Lump Sum Funding
A home equity loan allows you to gain access to the entire loan amount up front. This makes it great for large, one-off expenses such as home renovations or emergency medical bills.
Fixed Payments
Most home equity loans have fixed interest rates, which means that the amount you pay every month will stay the same for the life of the loan. This stability is great for budgeting, especially compared to variable-rate loans or lines of credit. With a fixed rate, you know exactly how much you need to pay every month.
It Might Be Tax-Deductible
According to the IRS, if your home equity loan is used to “buy, build, or substantially improve” the home against which the loan is borrowed, the interest payments on the loan are deductible on your taxes. It might not outweigh the standard deduction, but it’s worth speaking with your tax preparer about.
Cons of a Home Equity Loan
A home equity loan can be a great option for a lot of homeowners. As with any large financial decision, however, you should first compare the pros with the cons of a home equity loan. Let’s look at some of the potential drawbacks.
Risk of Foreclosure
The most significant risk of taking a home equity loan is the possibility that you could lose your house. This makes it essential for you to have a solid repayment plan in place. Financial instability or losing your job could make it difficult to keep up with payments.
Increased Debt
If you’re already paying a mortgage, a home equity loan adds debt on top of what you’re already paying every month, which can increase financial pressure. This is especially true if other loans, such as credit cards or student loans, are in play. Before taking on extra debt like a home equity loan, do an honest assessment of your financial obligations.
Loan Costs and Fees
Much like taking out a mortgage, home equity loans often come with fees, such as closing costs and origination fees, which can add up and cut into the overall financial benefit of the loan. Factor these into the overall loan cost to avoid unexpected strain.
Home Equity Loans: Are They Right for You?
These loans can be valuable tools for homeowners in specific situations, like taking a lump-sum loan for a high-return home renovation project. If you use a home equity loan to improve your home, you increase its value and thereby increase your equity as well.
When the funds are being used for non-essential expenses, on the other hand, the risks may not be worth it. Financing a vacation with a home equity loan, for instance, could increase financial stress and risk your house with very little reward.
If a home equity loan isn’t quite right for your needs, you can consider other alternatives instead:
- Personal loans: These are great for taking out a smaller amount of money and won’t risk your home. These loans usually have higher interest rates than home equity loans.
- Home equity line of credit (HELOC): A HELOC provides access to funds as needed, up to an approved limit, making it better for ongoing expenses that aren’t necessarily fixed. The variable interest rate means that it’s less stable for budgeting.
- Cash-out refinance: This replaces your current mortgage with a new, larger mortgage, letting you borrow additional money from your equity and take the difference as cash. This can provide funds without creating a second mortgage but typically comes with its own set of fees and higher monthly payments. Your house is still on the line if you default.
For more information on home equity loans, talk to your trusted lending institution. If you’re in New York State, talk to the experts at Mid-Hudson Valley Federal Credit Union, who can help you decide if a home equity loan is right for you.
I didn’t know I needed to consider all these options for a home equity loan. I’m bookmarking to read it again. Such helpful info.
This was such a clear and informative breakdown of home equity loans! I appreciate how you laid out the pros and cons in a way that makes it easy to understand.
Love this! You broke it down so well. We should always weigh the pros and cons before making a big financial decision and this makes it super easy to understand. The responsible borrowing tips are great! Thanks for sharing—definitely a must read for anyone considering this.
Taking out any type of loan needs fool proof planning . It’s a big step and one that should be taken with care. Your post is very informative and helpful.
There is a real need for this information right now. The price of EVERYTHING is just so high.
We opted for a home equity line of credit rather than a loan to avoid some of the fees. It worked well for us though. It’s there if we need it, and if we don’t, we pay nothing.