One of the benefits of homeownership is that you can access your home’s equity.
Home equity loans are one of the most popular ways to borrow money against the equity you’ve built in your home.
While home equity loans can be an excellent resource in certain situations, they do come with some risks for homeowners.
So is a home equity loan a good idea? Let’s discuss how home equity loans work, situations where it makes sense to consider taking one out and some possible alternatives.
How Do Home Equity Loans Work?
Home equity loans allow homeowners to borrow a lump sum of money by leveraging the equity they have in their home. They’re considered a type of second mortgage secured by your property. Home equity loans are commonly used to cover home improvement projects, buy real estate, consolidate debt and pay for education or emergency expenses.
With a home equity loan, lenders allow you to borrow up to 85% of the equity you have in your home. You can calculate how much equity you have in your home by subtracting the balance of any mortgages from the current market value of your property.
Once you take out a home equity loan, you’ll pay it back in monthly installments. Like your primary mortgage, your monthly payments on a home equity loan include the principal amount you borrowed plus interest charges.
Generally, home equity loans have slightly higher interest rates than first mortgages. Although, you may find they’re considerably lower than other loan types, such as personal loans and credit cards.
When Is Getting a Home Equity Loan a Good Idea?
Getting a home equity loan can be a good idea if you’re comfortable with the monthly payments and have a solid plan for how you want to spend the money.
For example, say you want to use a home equity loan to make some renovations to your home, which will not only improve your quality of living, but help increase the value of your property, too. You’ll also be able to deduct the interest charges on a home equity loan if the proceeds are used to substantially improve your home. In some cases, you might even be able to get a tax break on certain home improvements, like energy-efficient upgrades.
Another reason it might be a good idea to get a home equity loan is to consolidate debt. Say you have $75,000 in loans with an average interest rate of 10%. If you have the opportunity to pay that off by taking out a home equity loan with an 8% interest rate, you’ll save thousands of dollars in interest charges over the life of the loan.
Before taking out a home equity loan to consolidate debt, it’s important to develop good spending habits. And once you take out a home equity loan, you’ll want to avoid taking on any more debt until you pay off that loan completely.
When Is Getting a Home Equity Loan a Bad Idea?
Sometimes, getting a home equity loan isn’t the best idea – even if you’re offered a very competitive interest rate.
With a home equity loan, you’re using your home as collateral. That means if you fail to make all your monthly mortgage payments, it’s not just your credit on the line. It’s your actual home.
Taking out a home equity loan should help you improve your circumstances or increase your home’s value in some way. Using a home equity loan to pay for a wedding or buy a home theater system is unlikely to do so.
If you’re thinking about using a home equity loan, consider the following risks:
- Your home is on the line.
- Your home’s value can fluctuate with the market.
- You’ll receive the money in one lump sum, even if you don’t need it all right away.
Alternatives to Home Equity Loans
If you want to finance a wedding, an education or another major expense, there are several alternatives to home equity loans.
A cash-out refinance replaces your current mortgage with a new one. Your new mortgage will include a loan for a portion of the equity you’ve built up in your home, which you’ll receive in cash. If you like the idea of borrowing a lump sum of cash from your home’s equity, a cash-out refi can be a great option if you can get a lower interest rate on the new mortgage.
An unsecured personal loan lets you borrow money without any collateral. So you won’t have to risk losing your home, car or other assets to secure the loan. Personal loans give you plenty of flexibility, though they tend to have lower loan limits and higher interest rates than home equity loans.
Home Equity Line of Credit (HELOC)
Like a home equity loan, a HELOC is a second mortgage that allows you to borrow money against your home’s equity. A HELOC starts with a draw period where you can borrow money as needed, typically 10 – 15 years. During this time, you’ll only have to make interest payments on the money you borrow. After the draw period concludes, the repayment period begins. This lasts for around 20 years, and you’ll pay both interest and principal.
Choosing between a home equity loan and a HELOC is a personal choice. If you want a set interest rate, fixed monthly payments and need all or most of the money right away, a home equity loan could be the better option. However, if you’re not sure how much money you need to borrow and don’t mind an interest rate that can fluctuate, a HELOC might be the better choice.
If your sole objective is to get a tax deduction, you probably shouldn’t take out a home equity loan. However, if you want to make improvements to your home anyway, a tax deduction can be an added bonus of a home equity loan.
Paying back a home equity loan works a lot like paying your regular mortgage. Every month, you’ll have to pay a monthly installment consisting of a portion of the principal (the amount you borrowed) and interest charges. Home equity loan terms vary, but they typically range from 5 – 20 years.
It Can Be Risky Business Taking Out a Home Equity Loan
Home equity loans can be a useful tool for financing home improvements and other expenses, but their benefits are accompanied by some risks you need to take seriously. As with any other loan, it’s important to develop a financial plan around your personal situation and goals to avoid taking out risky or high-interest loans. When in doubt, talk to your financial advisor about home equity loans and other ways you can borrow cash.
The Short Version
- Home equity loans can be a good idea if you’re using the proceeds to fund home improvements that increase your property’s value
- The main risk of home equity loans is that if you don’t pay back what you borrow, you could lose your home to foreclosure
- If you’re looking for an alternative to a home equity loan, consider a cash-out refinance, a home equity line of credit (HELOC) or a personal loan
National Credit Union Administration. “Home Equity Loans & Lines of Credit.” Retrieved December 2022 from https://www.mycreditunion.gov/life-events/consumer-loans/home-equity
Internal Revenue Service. “Publication 936 (2021), Home Mortgage Interest Deduction.” Retrieved December 2022 from https://www.irs.gov/publications/p936#en_US_2021_publink1000229996
Internal Revenue Service. “Energy Incentives for Individuals: Residential Property Updated Questions and Answers.” Retrieved December 2022 from https://www.irs.gov/newsroom/energy-incentives-for-individuals-residential-property-updated-questions-and-answers