Is A Home Equity Loan A Good Idea For Your Finances?
Homeownership comes with plenty of benefits. One big perk is building equity in a property as you pay down your mortgage. You can tap into this growing value through a home equity loan.
It’s natural to ask yourself the question, “Is a home equity loan a good idea?” The short answer is that it depends on your financial situation. Let’s explore the benefits and risks of a home equity loan below.
Understanding Home Equity
Home equity is the value you’ve stored in your home. You can calculate home equity by subtracting the remaining mortgage balance owed from the market value of your home.
If you want to tap into the money you own in the home, a home equity loan can help. Essentially, it is a type of second mortgage that allows you to borrow a lump sum based on the amount of equity you have in your home. In general, homeowners can access funds through a home equity loan at a lower interest rate than other financing solutions, like personal loans or credit cards.
But most lenders cap how much of your home equity you can borrow. Many homeowners can choose to borrow up to 85% of their home’s value.
For example, let’s say your house is worth $400,000, and you have a $100,000 mortgage balance. You are left with $300,000 in home equity. If the lender allows you to borrow 80% of your equity, you might be able to get a home equity loan of up to $240,000.
Benefits Of A Home Equity Loan
A home equity loan comes with many benefits for homeowners. You’ll find a closer look at these benefits below.
You Qualify For Lower Interest Rates
A home equity loan is a type of secured loan, which means the lender uses your home as collateral. If you default on the loan, the lender can foreclose on your home. Ultimately, the secured nature of the loan lowers the risk for lenders. With that lower risk, lenders can offer lower interest rates.
As a borrower, the ability to tap into lower interest rates can be a game-changer for your finances.
You Can Get A Fixed Interest Rate
Home equity loans can offer a fixed interest rate, which means your monthly payment will never change. This stability in your payment makes it easier to budget for this loan repayment. In contrast, an adjustable-rate mortgage (ARM) comes with fluctuating payments that could throw a wrench in your budgeting plans.
You Get One Lump-Sum Payment
Home equity loans provide you with a lump sum of funds upfront, which you can use immediately for any purpose. Unlike lines of credit, you won’t have the temptation of dipping back into your home equity again anytime soon.
You Might Qualify For Home Improvement Tax Deductions
If you use the funds from a home equity loan for eligible home improvements, then you might qualify for a tax deduction. For example, you might be able to deduct the interest from your home equity loan if you use the funds to repair your home’s roof.
You Might Find A Long Repayment Timeline
A home equity loan might come with a long loan term. In some cases, you can find loan terms of up to 30 years. The extended timeline usually makes for a more affordable monthly payment. You can fit the smaller monthly payment into your budget, but you’ll always have the option to repay the loan ahead of schedule.
You Might Have Significant Equity
Homeowners with significant equity in their home may be able to access large loan amounts. If the lender is willing to provide a loan equal to 80% of the home’s value, then a homeowner with $200,000 and no outstanding could access a $160,000 home equity. As a homeowner, the ability to access so much capital can solve a range of financial issues.
Risks Of A Home Equity Loan
Of course, home equity loans also come with risks. Below is a closer look at the drawbacks of a home equity loan.
You Pay Closing Costs
When you pursue a home equity loan, you’ll have to pay closing costs. The costs you might encounter include appraisal fees and origination fees. Depending on the size of your loan, closing costs can add up quickly.
Your Credit Score Can Take A Hit
When you apply for a home equity loan, it’s likely that your credit score will temporarily drop. The hit to your credit occurs because you’ve applied for a new loan. If you consistently make on-time payments to the new loan, your credit score should recover quickly.
You Have Two Monthly Payments
A home equity loan is usually a second mortgage. When you add this new monthly payment on top of your existing mortgage payment, the costs can consume a big part of your budget. You’ll need to keep up with both payments to avoid the risk of foreclosure.
You Could Be At Risk Of Foreclosure
Since your home serves as collateral for a home equity loan, defaulting on the loan could lead to foreclosure. While this drastic step is usually a last resort for mortgage lenders, it’s a possibility for homeowners unable to keep up with this second payment. Putting your home on the line makes it critical to keep up with the payments.
You Might Encounter A Long Application Process
The application process is similar to procuring a home loan. While it might not take as long to get a home equity loan, it still involves an extensive level of paperwork. The paperwork means it can take weeks to finalize the loan. With that, a home equity loan isn’t a great option if you need cash immediately.
You Might Not Solve The Deeper Issue
If you’re considering a home equity loan, it’s critical to consider the reasons behind your choice. A home equity loan can give you access to a big pile of cash, but that might not solve deeper financial issues.
For example, using a home equity loan to consolidate debt without evaluating or changing your spending habits could be a recipe for disaster. Or using the funds to invest in a risky asset could put both your home and your financial future at risk.
Before you apply for a home equity loan, take a look at your overall financial situation. In some cases, it might not make sense to add a hefty loan into the mix. Instead, it might be time to adjust your spending habits.
Alternatives To A Home Equity Loan
A home equity loan isn’t the only way to find the funds you need. Below are some other options to consider.
Home Equity Line Of Credit (HELOC)
A home equity line of credit (HELOC) might be better for homeowners with undefined financial purposes. For example, if you have a few home renovation projects in mind for the next couple of years but are unsure of the exact costs, you can access your equity and repay it repeatedly through a HELOC’s draw period. HELOCs use your home as collateral just like a home equity loan, so avoiding default is crucial. Just keep in mind that some lenders do not offer HELOCs.
A cash-out refinance also lets you turn your equity into a lump sum payment. The difference is you still have one mortgage after the refinance, which means you’ll replace your existing mortgage balance with a larger one. In the process, you might receive an even lower mortgage rate if you have excellent credit and rates are lower than your current mortgage rate. Like home equity loans, cash-out refinances may have hefty closing costs.
A personal loan has the opposite set of advantages and disadvantages from a home equity loan. A personal loan requires no collateral, meaning you won’t risk losing your home. However, the lack of collateral means you’ll receive a higher interest rate and pay more for the loan.
Credit cards are straightforward financial tools for many purchases. Furthermore, credit card companies typically offer new customers an introductory 0% APR for several months to a year, allowing them to carry interest-free debt for an extended time. However, once it kicks in, the interest rate on credit cards is higher than almost every other form of debt.
Should I Get A Home Equity Loan?
A home equity loan offers a financial solution for many homeowners. It can help cover costs in a range of situations, including:
- Consolidating debt
- Paying for medical bills
- Paying for college
- Making home improvements
If you have a specific goal for the funds in mind, then a home equity loan might make sense. For example, if you plan to use the funds to replace your roof or consolidate debt, you’ll know exactly how much you need to move forward. The lump sum and low interest rates associated with home equity loans might be the right fit.
However, if your plans for the funds are less concrete in nature, then a different funding solution might make sense. For example, if you plan to make a series of renovations to your home or pay for an ongoing string of medical bills, then a more flexible solution might suit your needs. A HELOC, which allows you to draw out funds as needed might offer the flexibility you desire.
Take some time to weigh out the options for your situation before moving forward with a home equity loan.
The Bottom Line
A home equity loan is the right funding solution for many homeowners. It offers a lump sum with lower interest rates than other loans. But the risk of foreclosure may give you pause. If you’ve decided that this type of loan is the right move for your finances, apply for a Home Equity Loan today.