Benefits of a home equity loan include consistent monthly payments, lower interest rates, long repayment timelines and a possible tax deduction.
Downsides of a home equity loan include needing a 20% minimum ownership stake and strong financials; incurring closing costs; and the potential to lose your house if you default on payments.
Alternatives to home equity loans include HELOCs, cash-out refis, personal loans and reverse mortgages.
When you’re in need of financing, you can choose between two main types: secured loans, which require collateral to back (secure) the debt; and unsecured loans, which don’t. Home equity loans fall into the former category, with your home serving as the collateral.
A home is a lot to lay on the line. Are home equity loans a good idea? Let’s weigh the pros and cons.
What is a home equity loan?
A home equity loan is a type of second mortgage that allows you to obtain a fixed amount of money by leveraging some of the equity in your home — that is, the difference between your home’s value and what you still owe on your mortgage. You can borrow a fixed amount of money based on the size of this equity, or outright ownership, stake.
A home equity loan comes with a fixed interest rate and gets repaid just like a mortgage: monthly payments over a set period, which can be as long as 15, 20 or even 30 years. You can use the funds for any purpose, whether it’s covering educational costs, remodeling your home, or managing medical expenses.
Pros and cons of a home equity loan
“Home equity loans offer the stability of fixed interest rates and consistent monthly payments, making them great for big expenses like home improvements. However, the loans use your home as collateral, meaning missed payments could lead to foreclosure,” says Linda Bell, senior writer, home lending for Bankrate. “It’s all about balancing the benefits with the responsibilities.”
Pros of a home equity loan
Predictable interest rate: A home equity loan has a fixed interest rate throughout the entire loan term, which means that, regardless of fluctuations in the market, your interest rate won’t change. You’ll know exactly how much you’re paying to take out the loan and don’t have to sweat out skyrocketing rates.
Consistent monthly payments: Since the interest rate remains fixed, your monthly mortgage payment will also remain consistent over the life of the loan. This consistency can make it much easier to plan and budget your monthly expenses.
Relatively lower interest rates: Home equity loans typically offer lower interest rates compared to personal loans or credit cards. “While you may pay closing costs or other fees, it’s an inexpensive alternative to an unsecured loan,” says Laura Sterling, vice president, Marketing at Georgia’s Own Credit Union in Alpharetta, GA. Being backed (secured) by your property reduces the loan’s risk for banks and mortgage companies, and so they charge less for it.
Extended repayment periods: Home equity loans come with long repayment timelines spanning up to 30 years. This extended period, combined with a relatively lower interest rate, could translate to more manageable monthly payments.
Larger borrowing potential: Depending on the size of your equity (ownership) stake, a home equity loan might allow you to obtain larger sums than you could with a credit card or personal loans. We’re talking five- and six-figure sums that can be used to finance home renovations, tackle high-interest debt, or fund emergency repairs.
Tax advantages: If you use the funds from the loan to make significant home improvements or repairs, the interest you pay on the home equity loan is tax-deductible (assuming you itemize deductions on your return). This can provide you with additional savings and potentially reduce your overall tax burden.
Cons of a home equity loan
Chance of losing your house: Simply put, if you don’t repay the loan, your lender could foreclose. Aside from displacing you and other occupants, a foreclosure does long-lasting harm to your credit, making it more difficult for you to get a mortgage or other types of financing for some time.
Minimum equity requirement:You typically can’t take out a home equity loan unless you have at least 20 percent equity — that is, own one-fifth of your home outright. If you’re a new homeowner and didn’t put a lot of money down, you’ll probably need to wait a while before you can tap your equity at all. In addition, for approval you’ll probably need stronger financials than you would for a personal loan or credit card.
Closing costs: Home equity loans come with charges such as origination and appraisal fees. Closing costs are often around 1 percent of the total loan — less than primary mortgages — but they can still be considerable
Longer funding time: The process isn’t quite as onerous as that of a traditional mortgage, but applying for and receiving the funds with a home equity loan takes longer than the process of getting a personal loan — often, a month or more. Not the greatest of options if you need cash fast.
Deeper into debt: A home equity loan dilutes the value of a major asset, your home: You’re turning something you own (your equity stake) into something you owe. Not only are you adding to your monthly obligations, if there is a significant drop in the local residential real estate market, the value of your home might decline too, leaving you “underwater”: Your home-backed loan balances exceed the property’s value. “You could owe more on your home than it is worth, making it hard to sell,” Sterling says.
Not only are you adding to your monthly obligations, if there is a significant drop in the local residential real estate market, the value of your home might decline too, leaving you “underwater”: Your home-backed loan balances exceed the property’s value. “You could owe more on your home than it is worth, making it hard to sell,” Sterling says.
Risk of negative equity: If there is a significant drop in the local residential real estate market, the value of your home might decline, leaving you “underwater”: Your home-backed loan balances exceed the property’s worth. “If your home value declines, you could owe more on your home than it is worth, making it hard to sell,” Sterling says.
Do all home equity loans have fees associated with them?
Most lenders charge fees for a home equity loan. Count on possibly paying for the following:
Origination fee: The amount varies depending on the lender and how much you’re borrowing.
Appraisal fee: This usually costs anywhere from $300 to $800.
Credit report fee: The lender will charge you a nominal fee to pull your credit report, as little as $10 or up to $100 per credit report.
Title fees: Since the home serves as collateral for a home equity loan, lenders conduct a title search to determine if there are any existing liens or claims on the property. This fee can fall within the range of $75 to $200, depending on location; some go as high as $450.
Discount points: Some lenders allow you to pay upfront fees, known as “points,” to lower your interest rate. Each point costs 1 percent of the borrowed amount.
“Shopping around for lenders is a smart move to ensure you get the best deal on fees,” Bell says. “Starting with your current lender can be beneficial since they may offer you special rates for being a loyal customer. And don’t hesitate to negotiate—lenders often have some flexibility, and asking for lower fees or better terms can save you money in the long run.”
Home equity loans vs. HELOCs: What’s the difference?
Both home equity loans and HELOCs (short for home equity line of credit) let you borrow against your home equity, with your property serving as collateral for the debt. But they work differently.
When you take out a home equity loan, you’ll receive the funds in a lump sum. On the other hand, HELOCs are revolving lines of credit — like credit cards — letting you withdraw money as you need it. Home equity loans have fixed interest rates, while the rates on HELOCs are typically variable.
With a home equity loan, your monthly repayment amount will remain the same for the life of your loan (usually 10 to 30 years). In contrast, HELOCs have an initial 5- to 10-year draw period, when you can take out money as needed – and, optionally, only pay back the interest. After that, you’ll enter the repayment period, which generally lasts between 10 and 20 years. During this time, you’ll have to pay back the amount you borrowed, plus interest. You can no longer withdraw funds.
Other alternatives to home equity loans
Home equity loans can be difficult to qualify for. If you don’t think you can get one, or simply don’t feel it’s the best choice, explore these other options:
Cash-out refinance: A cash-out refinance involves replacing your existing mortgage with a new loan for a larger amount. You receive the difference (based on your home equity) in ready money. The main upside: You’ll have one monthly payment instead of two. The downside: If you are currently paying a low interest rate, it might not make sense to get a new loan, especially if rates have risen since.
Personal loan: Personal loans don’t require collateral, so your home and any other assets are safe. However, you typically can’t borrow as much with a personal loan, and you’ll have to repay it sooner. And you’ll almost certainly pay a higher interest rate compared to a home equity loan.
Reverse mortgage: For those who are 62 and older (or 55 and older with some products): a home loan in which the lender pays you each month. Unlike a HELOC or a home equity loan, the money withdrawn doesn’t have to be repaid in monthly installments. However, the principal, plus interest, must be repaid when the borrower dies, permanently vacates or sells the home.
FAQ: home equity loan pros and cons
How do the pros and cons of a home equity loan compare to HELOCs?
With a home equity loan, you receive a lump sum upfront, making it suitable when you have a specific expense or amount in mind. It also provides the advantage of a fixed interest rate for the entire loan term.In contrast, HELOCs offer a revolving line of credit: You have the flexibility to borrow (and pay interest on) only what you need, when you need it. HELOCs are suitable if your total costs aren’t well-defined or you have substantial expenses that will span an extended time frame.However, a HELOC comes with a variable interest rate, meaning that your monthly payments can increase.
Can you get a home equity loan without a mortgage?
Yes. You can take equity out of your home even if you own it free and clear. In fact, it might be easier to get a home equity loan if you’re mortgage-free: Because your residence doesn’t have any other debts attached to it, you can access a much larger amount of your ownership stake. Plus, without a monthly mortgage payment, you probably have a low debt-to-income ratio, which means you could qualify for a better interest rate on the loan.
When should you use a home equity loan instead of refinancing your mortgage?
A cash-out refinance pays off your existing mortgage and replaces it with a new one – and that includes a new interest rate and repayment term. Going that route might make sense if rates have dropped since you took out your original loan and you plan to stay in your home a while longer (or at least long enough to recoup the refi closing costs). However, if you’re happy with your current rate, then leaving your mortgage alone and going for a home equity loan would be a better strategy.
