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. 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- to 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.

HELOC Vs. Home Equity Loan

A HELOC and home equity loan are two popular methods of borrowing against the equity you’ve built in your home. The biggest difference between the two is that a home equity line of credit (HELOC) is a revolving line of credit, while a home equity loan is a fixed-rate loan.

With a HELOC, you can draw from the line of credit, repay it and draw from it again. 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, so you won’t have predictable monthly payments like you would with a home equity loan.

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, a HELOC comes with variable rates which 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 will increase the value of your property.

Potential To Borrow A Large Amount Of Money

Many lenders will allow you to borrow up to 85% of your home’s value, which can be a significant amount of money. For example, 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

Home equity 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

Cons Of Home Equity Loans

Here are some of the biggest downsides 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’ll qualify for a home equity loan.

Stricter Requirements

Home equity loans come with stricter requirements than other types of loans. You’ll need a minimum credit score of 620, so these loans aren’t a great option for borrowers with bad credit. You’ll also need a debt-to-income (DTI) ratio of 43% or less and 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 a home equity loan, you’ll have to pay closing costs. These costs include an application fee, appraisal fee, a title search fee and a credit report fee. You can expect to pay between 2% and 6% of the total loan amount in closing costs.

Your Home Is Collateral

Since your home is used as collateral for the loan, your lender can foreclose on your home if you’re unable to repay the loan. 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 On 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 a home equity loan, you could end up with negative equity – owing more on your loan than your home is worth.

3 Home Equity Loan Alternatives

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

1. 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.
2. 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.
3. 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.

The Bottom Line

Home equity loans are available to homeowners with good credit who have built significant equity in their homes. These loans come with fixed interest rates, predictable monthly payments and a possible tax deduction. If you’re ready to explore this option, you can apply for a home equity loan online today.