The Pros And Cons Of Home Equity Loans: What To Consider

If you need cash to cover a home improvement project or consolidate debt, taking out a home equity loan could make sense.

Home equity refers to the share of your home that you’ve paid off versus what your house is worth. If your house is worth $300,000, but you still owe $150,000 on your mortgage, then your home equity is $150,000 ($300,000 - $150,000).

A home equity loan provides access to a large sum of money by leveraging the equity you’ve built in your home. However, it’s important to consider the pros and cons of home equity loans first.

What Is A Home Equity Loan?

A home equity loan is a second mortgage that allows you to borrow against your home equity using your home as collateral. These fixed-rate loans are paid out in one large lump sum and then repaid over 5 – 30-year repayment terms.

A home equity loan may be a good idea if you’re looking to make home improvements or consolidate debt at lower interest rates. However, since you’re using your home as collateral, the bank can foreclose on your home if you’re unable to repay the loan. A good plan can help you weigh home equity loan pros and cons.

Home Equity Loan Pros And Cons: At A Glance

Pros Of Home Equity Loans

A home equity loan is a good option for homeowners looking for low interest rates and predictable monthly payments. Here are some of the biggest benefits of taking out a home equity loan.

Fixed Interest Rate

Home equity loans come with fixed interest rates, and the rates tend to be lower than other types of loans. In comparison, versus other options with variable rates that fluctuate depending on what happens in the market.

Interest Can Be Tax-deductible

The interest paid on your home equity loan is tax-deductible if you use the funds to make home improvements. Plus, renovating your home can increase the value of your property.

Potential To Borrow A Large Amount of Money

Many lenders will allow you to borrow a large percentage of your home’s value, which can be a significant amount of money. For example imagine you’re approved to borrow 85% of your home’s value. If you have a $400,000 home and owe $100,000 on your current mortgage, you can borrow up to $240,000. That’s because 85% of $400,000 is $340,000. And, since you already owe $100,000, you can still borrow $240,000.

Predictable Monthly Payments

These types of loans have fixed interest rates, so your interest rate stays the same regardless of what happens in the market. That means you’ll have predictable monthly payments for the life of the loan, which can make it easier to budget for your loan payments.

Use Funds For Any Purpose

Unlike other types of loans, home equity loans don’t put any limits on what you can use the funds for. You can use the funds to pay down debt, make home renovations or fund a major expense.

Cons Of Home Equity Loans

Here are some of the biggest disadvantages to consider before taking out a home equity loan.

Minimum Equity Requirements

Your home equity is the difference between what your home is worth and what you still owe on the mortgage. The longer you pay down your mortgage, the more equity you’ll build in your home. However, you must have at least 15% to 20% equity in your home before you qualify for this type of loan.

Stricter Requirements

Home equity loans come with stricter requirements than other types of loans. You’ll need:

• A minimum credit score of 620
• A debt-to-income (DTI) ratio of 43% or less
• Proof of a stable income

However, requirements also depend on the lender. For example, Rocket Mortgage® requires a minimum credit score of 680 and a maximum DTI of 50%.

Closing Costs

When you take out this kind of loan type, you’ll have to pay closing costs. These costs include an application fee, an appraisal fee, a title search fee and a credit report fee. Closing costs are between 3% and 6% of the total home cost.

Your Home Is Collateral

When you take out this loan, the lender places a lien on your property. This lien gives the lender a legal right to your home as collateral for the loan. Since your home is used as collateral for the loan, your lender can foreclose on your home if you’re unable to repay it.

So you should think about whether it makes sense to use a home equity loan to refinance debt. Credit cards come with much higher interest rates, but your home isn’t at risk if you can’t repay the debt.

Potential To Be Underwater Un Your Loan

There’s always the possibility that property values could drop, and your home could be worth less than you paid for it. If that happens after you’ve taken out this kind of loan, you could end up with negative equity – owing more on your loan than your home is worth.

4 Home Equity Loan Alternatives

If you’re wary about using your home as collateral for a loan, here are four alternatives to consider:

1. Home equity line of credit (HELOC): With a home equity line of credit, you can draw from the line of credit, repay it and draw from it again. It’s also a type of second mortgage. This flexibility makes it a good option in situations where you don’t know exactly how much you’ll need to borrow. However, HELOCs usually have variable interest rates.
2. Cash-out refinance: When you do a cash-out refinance, you’ll refinance your home for more than it’s currently worth and receive the difference in cash. This is a good alternative to a home equity loan since you can access the funds you need without taking on a second mortgage.
3. Credit cards: Credit cards come with higher interest rates, but they’re also far less risky than a home equity loan – when it comes to losing collateral. This option may make sense if you can qualify for a card with a 0% introductory interest rate and pay off the balance before it ends.
4. Personal loans: Personal loans come with higher interest rates and shorter repayment terms, but they could be a good alternative to home equity loans. Like credit cards, personal loans are unsecured debt, so you aren’t putting your personal assets at risk.

HELOC Vs. Home Equity Loan

A home equity line of credit works like a credit card, letting you borrow what you need, when you need it, with flexible payments and variable rates. On the other hand, a home equity loan gives you a lump sum upfront with fixed rates and steady payments, perfect for big, one-time expenses. Both use your home as collateral, so it’s important to choose the one that fits your financial situation and borrowing style.

Reasons For A Home Equity Loan

There are a number of reasons why you might opt for a home equity loan, though they can generally be placed into two main categories.

• You need cash without restrictions on how to use it. Maybe you have to address medical debt, or you have someone in the family going to college soon, or you want to make some changes to your home. Home equity loans can be used for nearly anything, which makes them an appealing alternative to student or car loans. Note that only home improvements are tax-deductible.
• You have high-interest debt to pay off. You might have credit cards and other high-interest debt that needs to be paid off quickly to minimize interest payments and want to take off a lower-interest loan to do so.

How To Apply For A Home Equity Loan

The application process for a home equity loan is similar to that of getting a refinance.

Step 1: Check Your Qualifications

You’ll want to check your credit score and determine your debt-to-income (DTI) ratio, both of which will help you determine how likely it is to get a home equity loan.

Everyone is eligible for a free credit report from each of the three main credit bureaus every month through AnnualCreditReport.com, but most credit card companies and banks offer free score tracking, Be sure that everything on your credit report is accurate and up to date, as mistakes are common and can cause delays or even rejections for loans applications. Aim for a score of at least 620 for a home equity loan, though you will have a better chance with a score of 680 or higher.

Your DTI should be 43% or less, though again, you will have a better chance of getting a larger loan amount if you have a better DTI.

Step 2: Determine Your Home’s Value And Your Available Equity

Home equity loans are based off of your home’s current value, not the price when you first purchased it. You will need to get a home appraisal to find out what your house is currently worth, which will in turn allow you to find your available equity.

For example, if you have a $200,000 mortgage balance remaining, and your house is determined to be worth $550,000, you have $350,000 worth of equity that you can potentially tap into.

Step 3: Find A Lender

You don’t have to go back to your original lender for a home equity loan, though you certainly can. Shop around to get estimates of what loan amounts and interest rates are available to you from different lenders.

Step 4: Gather Your Documents

If you remember from your initial mortgage application journey, you will need to have your documents in order before applying. This includes tax returns, recent W-2s, pay stubs, financial statements, and anything else that can help explain your financial situation to a lender. This is especially important if you are self-employed or not currently working. It’s always better to give a lender more documentation than they need than it is to give them less so the application process can go smoothly.

Step 5: Get Approved

Your final step is to apply and get approved for your home equity loan. Now you’re ready to start on those renovations or pay those bills you’ve been worried about.

The Bottom Line: Home Equity Loans Are Great Financing Options

It’s a big decision to take out a home equity loan. Yet, it might be worth it for homeowners because of interest rates, predictable monthly payments and a possible tax deduction. Meeting the qualifications can help turn a house into a dream home.

Ready to explore this option? Start an application for a Home Equity Loan from Rocket Mortgage^® today.