Pros and cons of a home equity loan
Key takeaways:
A home equity loan lets you borrow against the value of your home.
Home equity loans tend to be larger and less expensive than personal loans.
Home equity loans are issued in one lump sum even if you don’t need all the money right away.
Looking for a way to pay off high-interest debt or fund a big-ticket expense? A home equity loan might be a smart solution.
A home equity loan is a way to borrow against your home to pay for a major expense over an extended period. You receive the funds in a single lump sum. Plus, you can get a fixed interest rate, which means it won’t change for the life of the loan. And because home equity loans are guaranteed by your home, they can be easier to qualify for than personal loans.
A HELOC (home equity line of credit) is similar to a home equity loan, but you don’t always have to take the entire loan at one time. You get a few years during which you can borrow, repay, and borrow more, up to your credit limit, as needed.
Pros and cons of a home equity loan
Pros | Cons |
|---|---|
The interest rate stays the same throughout the entire repayment period | Typical home equity loans are set up to last 30 years |
May have a higher maximum loan amount compared to personal loans | Limited loan amounts if you don’t have a lot of equity |
Monthly payments that are steady and predictable | Home equity loans are paid out in a lump sum |
May have a lower interest rate compared to other loans you qualify for | After the loan is finalized, you can’t borrow any more or any less |
You can decide how to use the money | Many lenders require a credit score of 620 |
|
6 advantages of a home equity loan
Fixed interest rate
The interest rate on your home equity loan remains the same throughout the duration of the loan. Your cost and your payment amount won’t fluctuate, and you’ll be protected from rising interest rates.
Predictable payments
Another advantage of a home equity loan is steady, predictable payments. Because your monthly payment remains the same, a home equity loan can make it easier to budget and manage your different financial goals.
Larger loans
Home equity loans tend to have a higher maximum loan amount compared to personal loans.
Lower interest rates
Because home equity loans are guaranteed by your home, they tend to have lower interest rates than other types of financing.
Flexibility
You can use the money for just about any financial priority. Here are some common uses of home equity loans:
Home repairs and maintenance
Renovations or upgrades
Consolidate other debts
Pay off medical bills
Pay for a family event
Other “life happens” events
Tax benefit
You may get a tax advantage with a home equity loan. If you are using the funds from your home equity loan to buy, build, or substantially improve the home that you borrowed against, the interest on your home equity loan may be tax deductible.
5 points to consider before taking a home equity loan
Repayment period
Most home equity loans are set up to last for 30 years. That can be easy on your monthly cash flow but hard on overall cost. The longer you take to pay back a loan, the more interest you’ll pay. A 30-year term more than doubles your interest charges compared to a 15-year term.
Limited by your home equity
All home equity lenders put limits on how much they’ll loan. Usually, there’s a dollar limit and a loan-to-value limit (or LTV). LTV means how much debt you have compared to your home’s value, and it includes your primary mortgage and the new loan you want.
If you don’t have a mortgage, your LTV is zero. If your home is worth $400,000 and you owe $300,000, your LTV is 75% (you owe 75% of the home’s value).
Equity is the opposite of LTV. If your LTV is 75%, your equity is 25%. It’s your share of ownership. Equity is increased in three ways:
When you make a down payment
As you pay down your mortgage
As your home value increases
If the lender’s LTV maximum is 80% and your LTV is 75%, there isn’t much room for a home equity loan. For example:
Current market value: $400,000
Current mortgage balance: $300,000
Lender’s loan limit (80% LTV): $320,000
Amount you could borrow: $20,000
If this is your situation and you need a bigger loan, a personal loan might be a better option.
Lump sum
A typical home equity loan requires you to pick a dollar amount even if you aren’t sure exactly how much you’ll need, or you don’t need all of the money right away. You get the entire amount as soon as your loan finalizes. That can be problematic. For example, if you’re undertaking a year-long remodeling project, you might not need all the money right away. But you’ll be paying interest on the entire loan from day one, whether you use it or not.
Can’t change loan amount later
Once your home equity loan is final, you can’t change your mind about how much you want to borrow. If you find that you don’t need the full amount, you can probably arrange to repay a chunk of the loan with your excess funds. But you can’t later decide that you need a little more, even if you’ve been steadily paying down your balance. To do that you’d have to get a new loan.
Credit score requirements
Most home equity loan lenders want you to have a credit score of at least 620. That’s good compared to personal loan credit requirements, which might be a little higher. But if your credit score is below 620, it may be hard to use a home equity loan to get back on your financial feet. You’d need to look for an option that allows a lower score. Some home equity loan lenders (not many) take applications from borrowers with a 640 credit score.
Choosing a loan
You can usually take out a home equity loan at a financial institution like a bank, credit union, or online lender. As you research options, it’s a good idea to also check out a home equity line of credit (HELOC).
A HELOC has some advantages. Primarily, you don’t have to take the full loan amount up front. Like a credit card, a HELOC lets you borrow, repay, and borrow more, up to your credit limit, for the first few years. Most HELOCs have a variable interest rate, so your costs can fluctuate. The best kind of HELOC has a fixed interest rate, which means you're protected from rising interest rates for the life of your loan.
Comparison shop
Find a lender who can help you prequalify before you apply for a loan. This will give you an idea of the loan amount, rates, and terms that you can qualify for. Unless your financial situation changes a lot between the time you prequalify and the time you apply, the quote you receive when prequalifying will be similar to the one you get when you apply.
Prequalification results in a soft pull on your credit, which won't negatively impact it. Once you apply, your credit score can temporarily lose a few points.
Know the numbers
Beyond the loan amount, interest rate, and length of the loan, understand what the closing costs are. For example, some loans advertise very low interest rates but have very high fees.
Ask about other fees, too. Is there a prepayment penalty? What happens if you make a late payment? Check the lender’s website or discuss these things with the loan officer.
Don’t rush into a decision
Whatever loan you choose, you’ll ultimately need to pay it back. Since you’re borrowing against your home, it makes sense to borrow wisely. Make sure your reason for borrowing is appropriate, and get all the information you need before you sign any documents.
Other options for homeowners
Cash-out refinance mortgage
A cash-out refinance is a new mortgage for more than you owe on your current mortgage. The lender pays off your first mortgage and you get the difference in cash. When you’re comparing a cash-out refinance vs a home equity loan, one consideration is that this strategy leaves you with only one monthly payment. If you take a home equity loan, you’ll make two separate payments - one on your mortgage and one on your home equity loan.
A cash-out refi might be a worthwhile option to explore if you can lower the rate on your mortgage debt. However, if you lengthen the life of your mortgage, you might end up paying more overall in interest. If your primary mortgage has a low interest rate, you might not want to replace it.
HELOC (home equity line of credit)
A HELOC is a secured loan, just like a home equity loan. Because it’s guaranteed by your home, the interest rate may be lower compared to what you could get on a personal loan or credit card.
One advantage of a HELOC is that you don’t have to take the entire loan amount at once if you don’t want to. A HELOC is a line of credit that you can borrow from as needed for the first few years. This is called the draw period.
Typical HELOCs have a variable interest rate, which leaves you vulnerable to rate increases in the future. It also means your payment requirements can fluctuate.
A better option is a fixed-rate HELOC, which combines the best features of home equity loans (the fixed interest rate) and HELOCs (the draw period).
Alternatives to borrowing against your home equity
Personal loan
A personal loan can be a solid alternative to borrowing against your home—especially if you need the money fast or a home equity loan isn’t a good fit.
For a personal loan, you don’t have to own anything or pledge an asset as a guarantee. You’ll qualify based on your credit standing. The amount you can borrow will also depend on your income and your other debts. The lender will make sure you can afford the payments.
Personal loans can fund as soon as the day after you apply. In contrast, most home equity loans take at least two weeks.
It’s true that personal loans tend to have higher average interest rates compared to home equity loans, but not all borrowers pay more for personal loans. It depends on your credit, how much you borrow, the loan repayment term you choose, and whether your lender offers interest rate discounts. The best way to price it out is to talk to a loan specialist who can look at the details of your situation.
Debt resolution
If your goal is to get out of debt, debt resolution may be an option. Debt resolution means negotiating with your creditors to accept less than the full amount you owe. The way it usually works is that you have to be prepared to pay a lump sum as soon as your offer is accepted. If you don’t have money set aside, you'll want to save up before reaching out to negotiate.
Creditors don’t usually negotiate with consumers who are reliably paying their bills. Debt resolution is a strategy that works best for people who are already in default or who have a financial hardship that's going to cause them to go into default very soon.
You can do debt resolution yourself or you can hire a professional to help you. If you hire a reputable company, it’s common for them to help you set up a dedicated account where you can build up the funds to make offers. It’s still your money and you have access to it. When the company successfully negotiates a debt, they take their fee from the same account.
It’s against the law for a debt negotiator to charge you up front or to guarantee results, so when you do your research, keep an eye out for these red flags.
Frequently asked questions
What is a HELOC?
A HELOC, short for home equity line of credit, is a secured loan. You pledge your home as a guarantee that you’ll repay the loan. The HELOC itself works like a credit card. You can borrow, repay, and borrow again up to your credit limit as often as you want for the first few years. This is called the draw period. The number of years depends on the lender, but is usually at least five.
HELOCs are a way to access your home’s value in cash without selling your home.
Most HELOCs have a variable interest rate, which means your costs can be unpredictable. With a fixed-rate HELOC, the interest rate won’t budge for the entire length of your loan. This makes it easier to budget and plan your financial life.
How does a home equity loan work?
A home equity loan is secured by your home. It’s a second mortgage. Most home equity loans have a fixed interest rate, which means you’re protected from rising rates in the future. You get a lump sum when the loan is finalized, and a set period of time to pay it off.
Is it a good idea to get a home equity loan?
A home equity loan can be a tool to reach a goal that’s important to you. Some people use home equity loans to improve their home. Others use it as a way to pay off higher-interest debts.
It’s generally not considered a good idea to use a home equity loan for a luxury item that is beyond your means, such as an expensive vacation.
