Pros and cons of a home equity loan

If you’ve built equity in your home, you might already have a key resource to handle a major expense. Your home equity could unlock an affordable way to borrow to reach your financial goals.

A home equity loan lets you borrow against the equity in your home and repay it in fixed monthly payments over a set term. These loans often have lower interest rates than credit cards or personal loans. They’re secured by your home, which means missed payments could put your home at risk.

We’ll go through the advantages and disadvantages of a home equity loan. Advantages may include a relatively low interest rate and a fixed repayment period with predictable payments. The chief disadvantage is that you could lose your home if you don't make those payments. 

Being able to borrow against your home can be a valuable financial resource. Knowing the pros and cons of home equity loans will help you choose the right situations for using this resource.

Advantages of home equity loans

Here are some of the potential benefits of home equity loans:

• Lower interest rates. Home equity loans are secured by your property. That means they generally have lower interest rates than alternatives such as personal loans or credit cards.

• Fixed interest rates. Locking in an interest rate when you sign up for the loan means you'll know your total cost from the beginning.

• Predictable payments. A schedule of regular, unchanging payments allows you to budget precisely for those fixed payments.

• Larger loans. If you have a lot of equity in your home, a home equity loan may allow you to borrow more than typical limits on personal loans or credit cards.

• Multiple uses. Home equity loans can be used for a wide variety of financial goals, from home improvements to debt consolidation.

• Possible tax benefits. The interest you pay may be tax-deductible if the loan is used to substantially improve your home and boost its value. Consult a tax professional for details.

Disadvantages of home equity loans

Home equity loans may offer several advantages, but it’s smart to be familiar with the potential disadvantages:

• Risk of losing your home. If you don't repay the loan, the lender could have a legal claim on your home.

• Higher upfront costs. These costs may include a home appraisal and closing costs that exceed the initial costs of getting other forms of credit.

• Longer repayment period. Home equity loans are typically structured for repayment over five to 30 years. The longer you take to repay a loan, the more interest you typically pay.

• Limited by your home equity. Lenders generally require a cushion between the value of your house and how much you can borrow against it. If you haven't built up a lot of home equity, a home equity loan may not be an option.

• Credit score requirements. The specific credit score you need will vary by lender, but most require you to have a score of 600 or higher to qualify for a home equity loan.

• Less flexibility. Home equity loans mean borrowing the full amount upfront. This may not be the most efficient way to borrow if you're not sure of your project’s cost or you expect a series of financial needs at different times. 

Summary of home equity loan pros and cons

Here’s a side-by-side comparison of the pros and cons of home equity loans:

When a home equity loan makes sense

Given the advantages and disadvantages, how can you tell when getting a home equity loan is the right move?

Here are some situations when a home equity loan might make sense:

• If you have a substantial amount of equity in your home 

• If you need to borrow a large sum of money for use in the near future 

• When you want to lock in an interest rate for the life of the loan

• You want predictable monthly payments

• If you want to refinance high-interest debt with a relatively low-interest rate loan

• When you plan to be in your current home for several years

• If you have a stable income and are confident you can repay the loan

• When you plan to make improvements to the home that would qualify the interest payments for a tax deduction

• If you're comfortable with the risk of using your home as collateral and have a solid repayment plan

When a home equity loan might not be the right choice

Home equity loans aren't always the right fit. Here are some examples of when a home equity loan might not be the best solution:

• When you have less than 20% equity in your home

• If your credit score is won't meet lender requirements

• If you plan to move within the next few years

• If you're uncomfortable putting your home at risk 

• If you're uncertain about your income

• When the amount of money you need is small enough to be repaid in a few years

• When you won't need the money all at once or are unsure of the timing

Comparisons to home equity loan alternatives

Before committing to a home equity loan, it's wise to consider some of the alternatives:

• A home equity line of credit (HELOC) gives you more flexibility for using the money, since you can borrow, repay, and borrow more as much as you want during the initial draw period, up to your limit.

• A cash-out refinance mortgage may provide the money you need while shifting an existing mortgage to more favorable terms. Works best if you can qualify for a lower mortgage rate.

• A personal installment loan may require lower upfront costs and involve less risk, though it will likely have a higher interest rate.

• A zero-interest balance transfer credit card could be a cheaper way of refinancing high-interest debt if you have good to excellent credit and can repay the balance within the intro period. 

• If you're having serious difficulty paying existing debts, you may need debt relief. You could potentially settle high-interest credit card debt or personal loans you can afford to repay in full.

Home equity loans can be a cost-effective way to borrow money under the right circumstances. Consider the pros and cons and possible alternatives carefully to make sure a home equity loan is the best solution for your situation.