Home equity loans are also known as second mortgages. They are available for people who own a home and want to borrow money against the equity in their property. This is an attractive alternative to other types of loans because it has lower interest rates and can be used for any purpose.
If you have an account with a bank, credit union, or online lender, the chances are excellent that you’ve received multiple solicitations in the mail for a home equity loan. Financial institutions pitch them year-round and extoll their virtues by suggesting you use the money for home improvements, debt consolidation, or a family vacation. Every year, many homeowners respond to these advertisements and decide to tap into the equity in their homes. However, while home equity loans can be a convenient way to satisfy a significant cash need, they have drawbacks.
Is a home equity loan a good idea?
A home equity loan may be a good idea if you are confident you’ll be able to make your monthly payments on time, especially if the loan is used for home improvements or debt consolidation with a lower interest rate.
However, a home equity loan is not a good idea if it will strain your finances and cause you to struggle when making your payments. There is much at stake if you fall behind on a home equity loan besides late fees—namely, foreclosure.
Home equity loans are also not a wise solution to a monthly cash flow problem. If you seem to be $300 short each month and are falling behind on paying your bills, adding a home equity repayment to your budget is a temporary fix, at best. Your underlying financial issues like budgeting and saving still need to be addressed.
Pros and cons of home equity loans
Like every financial product, there are pros and cons of home equity loans. Let’s look at each.
- Fixed interest rate: unlike credit cards and a home equity line of credit (HELOC) which have variable interest rates that can increase unexpectedly with little notice, the interest rate on a home equity loan will not change for the life of the loan.
- Lower interest rate: because a home equity loan is secured by your property, lenders typically offer a lower interest rate than unsecured forms of borrowing such as credit cards or personal loans.
- Long repayment terms: depending on your particular loan and lender, home equity loan repayment periods can be as long as 20 years. Combining this long payback period with a lower interest rate equates to affordable monthly payments.
- Possible tax-deductible interest: you may be eligible to deduct the interest on a home equity loan (up to $100,000) if you use the money to substantially improve the property used to secure the loan. It’s advisable to consult with your tax advisor concerning deductibility.
- Foreclosure: the biggest drawback of a home equity loan is the possibility of losing your home. If you fail to pay your loan on time, your lender can foreclose.
- You need excellent credit: to qualify for the lowest rates on a home equity loan; your credit must be excellent. You can qualify for a loan with good credit, but your payments will be higher.
- You need substantial equity in your home: you generally must have between 15 to 20 percent equity in your property to be considered for a home equity loan.
- The loan balance must be paid when you sell your home: because a home equity loan is tied to your home, it must be paid off when you sell your residence. This can be a problem if your home’s value has decreased and you owe more than you can sell it for.
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Under the right circumstances, home equity loans can be beneficial.
For example, a couple with a two-bedroom home expecting a third child could opt to convert a study into a third bedroom by using a home equity loan to pay for the conversion. In this case, it could cost them considerably less than selling their home and buying a new residence.
A home equity loan can also be beneficial for debt consolidation. For example, if you have two credit cards with a total balance of $20,000 that carries a 22% interest rate and a $350 monthly payment, you would probably be better served by taking out a home equity loan for $20,000 at a 6.5% interest rate and a $125 monthly payment.
Under the right circumstances, a home equity loan can benefit a homeowner who wants a lump sum of money to make home improvements or consolidate bills. However, it may not be the right financial move for someone who is overextended with debt since it’s adding another payment to their already overtaxed monthly budget.
If you’re considering a home equity loan, you may want to consult your financial and tax advisors first. They can weigh the pros and cons of a home equity loan with you and, based on your financial situation, make a recommendation that will be in your best interests.
What are the risks of a home equity loan?
The major risk of a home equity loan is losing your home for failing to make your payments, but even late payments will incur extra fees and charges. In addition, the risk of your home losing value after you’ve taken out your loan may make it more difficult to sell your home.
How do home equity loans work?
When you apply for a home equity loan, your lender will look at your current loan payment history and credit history to determine your creditworthiness. If they deem you to be an acceptable risk, they can lend you up to 80 to 85 percent of the equity you have in your home, depending on the lender.
Does a home equity loan affect your credit score?
A home equity loan can initially negatively impact your credit score because you are increasing your debt load. Your score will also be negatively affected if you are late with your monthly payments. However, making payments on time can ultimately improve your score.