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.
A home equity loan allows you to use the equity you ’ve built to borrow money. This type of loan comes with its own pros and cons that you should be aware of before you make a move. Let’s explore the benefits and risks of a home equity loan.
Key Takeaways:
- Home equity loans are a way you can use the equity you have in your home as collateral to borrow money.
- Home equity loans typically come as a lump sum with a fixed interest rate that’s usually lower than you would get with other types of loans.
- There are also drawbacks to home equity loans – and if you can’t repay the loan, you could risk losing your home.
Understanding Home Equity Loans
You can think of home equity as the amount of your home you currently own, derived from the down payment and mortgage payments you’ve made. You can calculate home equity by taking the market value of your home and subtracting what you still owe on your mortgage.
If you want to tap into the equity you have built, a home equity loan can help. This loan is a type of second mortgage that allows you to borrow a lump sum using the equity in your home as collateral. Home equity loans also typically come with a lower interest rate than other, unsecured financing solutions, like personal loans or credit cards.
To get a home equity loan, lenders typically require that you have first built a minimum amount of equity in your home – often 15% to 20% of the total home value.
Most lenders also cap how much of your home equity you can borrow. While the exact limit can vary depending on the lender, homeowners can typically borrow up to 80% or 90% of their home’s value (minus their outstanding mortgage balance) with a home equity loan.
For example, let’s say your lender will allow you to borrow up to 90% of your home’s value. Your house is worth $400,000, and you have a $100,000 mortgage balance. If you multiply the value of the home by 0.90, you’ll get:
$400,000 x 0.90 = $360,000
Then, subtract the amount you still owe on your mortgage:
$360,000 – $100,000 = $260,000
This tells you that you could borrow up to $260,000 with a home equity loan.
Benefits Of A Home Equity Loan
A home equity loan comes with many benefits for homeowners. You’ll find a closer look at these below.
Lower Interest Rates
A home equity loan is a type of secured loan, which means the lender uses your home as collateral. 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.
Fixed Interest Rate
Home equity loans primarily come with 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.
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 being able to dip back into your home equity again anytime soon.
Potential Tax Benefits
If you use the funds from a home equity loan for eligible home improvements, then you should be able to deduct the interest on your home equity loan from your income taxes.
Flexible Repayment Schedule
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 that you can fit into your budget – and you’ll always have the option to repay the loan ahead of schedule.
You May Have Significant Equity
Homeowners with significant equity in their homes 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, for example, then a homeowner with a $400,000 home and no outstanding mortgage balance could access $320,000 in home equity. As a homeowner, the ability to access so much capital can solve a range of financial issues.
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Risks Of A Home Equity Loan
Home equity loans also come with risks. Below is a closer look at the drawbacks.
Closing Costs
When you pursue a home equity loan, you’ll have to pay closing costs that can add up to 2% to 6% of the loan amount. The costs you might encounter include an appraisal fee and an origination fee. Depending on the size of your loan, closing costs can add up quickly.
Two Monthly Payments
A home equity loan is 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.
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.
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 documentation. The paperwork means it can take weeks to finalize the loan, so a home equity loan might not be the best option if you need cash immediately.
Might Not Solve The Root Problem
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.
How To Protect Yourself From Home Equity Loan Risks
Let’s take a look at some of the steps you can take to avoid of the potential risks of home equity loans:
- Don’t miss payments. Stay on top of your monthly repayment schedule so you don’t fall behind on payments and risk foreclosure.
- Don’t borrow more than you can afford. Make sure you’ll be able to afford a second monthly loan payment. If you borrow too much, your monthly payment could be too high to fit into your budget.
- Shop around for the best interest rate. When you get a home equity loan, you don’t have to use the same lender you did for your first mortgage. Shop around with other lenders to get the best loan terms.
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Should You Get A Home Equity Loan?
If you have a specific goal for the funds in mind and know exactly how much money you’ll need, then 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 more 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 the options for your situation before moving forward with a home equity loan.
When A Home Equity Loan Is The Right Choice
Maybe you’re still wondering, “Should I get a home equity loan?” Here are some specific cases where a home equity loan can be a good move:
- You plan to use the funds for home improvements. If you use the money to complete home renovations, you can increase the value of your home and the total equity you have.
- You want to consolidate high-interest debts. Home equity loans typically come with a lower interest rate than credit cards and personal loans, which can help save you money.
- You need a large payment for medical expenses or a child’s college tuition. Home equity loans come as a lump sum and can help you cover major expenses.
When To Consider A Different Type Of Loan
There are also cases where a home equity loan might not be the best financing solution. Here are some examples of when you might want to explore a different option:
- You aren’t sure how much money you need for your project. If you don’t know exactly how much the project will cost, you might be better suited for a line of credit that you can withdraw from more than once.
- The additional monthly payment might stretch your budget. Be sure you can afford the extra loan payment each month, or else you could risk losing your home.
- You don’t qualify for competitive interest rates. If your credit is poor, you may not be able to enjoy the benefit of a low interest rate on a home equity loan.
- You’re buying something you can’t afford. A home equity loan still has to be repaid. It’s best not to risk your home for major nonessential purchases like a vacation or a fancy new car.
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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
A home equity line of credit 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 without a HELOC’s draw period. HELOCs use your home as collateral just like a home equity loan, so avoiding default is crucial. And keep in mind that some lenders do not offer HELOCs.
Cash-Out Refinance
A cash-out refinance also lets you turn your equity into a lump sum payment. The difference is you still have only 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.
Personal Loan
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.
401(k) Loan
Typically, if you withdraw from a 401(k) too early, you’ll have to pay taxes and incur a steep 10% penalty on whatever you withdraw. However, a 401(k) loan allows you to borrow money from your retirement account without taxes and penalties. This option allows you to bypass a lender, so when you repay the loan, all the money – including interest – goes back into your 401(k) account. 401(k) loans won’t ding your credit, even if you default, and they often come with lower interest rates than other loan options. However, borrowing money from your retirement account reduces the amount you have saved and how much it can grow. If you don’t repay a 401(k) loan, it will count as an early withdrawal, and you’ll have to pay taxes and penalties.
Credit Card
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 the intro period ends, the interest rate on credit cards is higher than almost every other form of debt.
FAQ
Here are the answers to some frequently asked questions about home equity loans:
The Bottom Line
A home equity loan is a way to access the equity you have in your home to borrow money. This loan option often comes with low interest rates, but it also means you’ll have an additional loan payment each month. A home equity loan can help you find financing for a project – but using your home as collateral means risking foreclosure if you can’t repay the loan.
Sarah Sharkey contributed to the reporting of this article.
Rory Arnold
Rory Arnold is a Los Angeles-based writer who has contributed to a variety of publications, including Quicken Loans, LowerMyBills, Ranker, Earth.com and JerseyDigs. He has also been quoted in The Atlantic. Rory received his Bachelor of Science in Media, Culture and Communication from New York University. He also completed the SoFi/Coursera Fundamentals of Personal Finance Specialization consisting of five courses: Introduction to Personal Finance, Saving Money for the Future, Managing Debt, Fundamentals of Investing, and Risk Management in Personal Finance.
