When you need to borrow money, there are two main categories of loans you might consider: unsecured and secured. Home equity loans are a type of secured loan, with your home attached as collateral. Here are the pros and cons.
What is a home equity loan?
A home equity loan is a type of second mortgage that involves borrowing a lump sum based on the amount of equity you have in your home. You can borrow the funds for various expenses, including college tuition, home improvements or medical debt, but you can’t borrow all of your equity to pay for them. Most lenders require you to maintain at least 15 percent or 20 percent equity in the property. Once you close the loan, you’ll pay it back in regular installments over a set period of time that can be as long as 30 years.
Pros and cons of a home equity loan
Anytime you’re thinking about a major financial move that involves putting your home on the line, it’s important to carefully consider the advantages and drawbacks. Here’s a rundown of the key pros and cons of home equity loans:
- Fixed interest rate: The interest rate on a home equity loan is fixed for the life of the loan, so even if rates move up and down in the market, your payments will never change. “When you take out a home equity loan, right from the start, you will know exactly how much you’ll have to pay back each month and what the interest rate will be,” says Sam Eberts, junior partner with financial services firm Dugan Brown.
- Lower rates relative to other loans: Because home equity loans are secured by your property, they typically offer a lower rate than unsecured forms of borrowing such as personal loans or credit cards. “While you may pay closing costs or other fees, it’s an inexpensive alternative to an unsecured loan,” says Laura Sterling of Georgia’s Own Credit Union.
- Long repayment timelines: The repayment terms on home equity loans can be as long as 30 years. This fact, coupled with lower interest rates than unsecured loans, can translate into a very affordable monthly repayment installment.
- Potential tax benefits: If you’re interested in taking out a home equity loan to make the home even better, you’re in luck: The interest paid on a home equity loan could be tax-deductible if you use the money to substantially improve the property used to secure the loan. “Because there are limitations on what you can deduct, it’s always best to consult your tax advisor,” says Sterling.
- The possibility of losing your house: “If you fail to pay your home equity loan, your financial institution could foreclose on your home,” says Sterling.
- The potential to owe more than it’s worth: A home equity loan takes into account your property value today. However, if the housing market crashes or your neighborhood becomes less desirable, the value could go down. “If your home value declines, you could owe more on your home than it is worth, making it hard to sell,” Sterling says.
- Credit and equity requirements: While it’s true that home equity loans generally offer lower interest rates than unsecured loans or credit cards, the most competitive rates are awarded to borrowers who have good to excellent credit. Likewise, qualifying for a home equity loan generally requires having between 15 percent to 20 percent in equity in your property.
Home equity loans vs. HELOCs
Both a home equity loan and a home equity line of credit (HELOC) put your home up as collateral when borrowing money. However, there are also some key differences between these two financial products.
Home equity loans
A home equity loan comes in a lump sum, so if you know exactly how much you need to borrow, it can be the better option. A home equity loan also comes with a fixed interest rate for the life of the loan and fixed monthly payments, which can be a safer bet, particularly in the current environment of rising interest rates.
“Home equity loans give you the security of knowing your exact monthly payments,” says Sterling of Georgia’s Own.
A HELOC is a revolving line of credit that functions like a credit card, albeit with much lower interest rates. You can borrow from a HELOC as needed during the draw period, which usually lasts 10 years. After that, you enter the repayment period.
There are many benefits to a HELOC, including the fact that you’re only responsible for repaying what is borrowed. HELOCs might be a good choice if you lack clearly defined borrowing needs or have costly, ongoing projects and will need to access cash over an extended period of time.
One of the most significant downsides of a HELOC, however, is that they come with a variable interest rate that can increase unexpectedly.
“You could get stuck paying higher interest rates while still having to make your regular mortgage payment simultaneously,” says Eberts of Dugan Brown.
In addition, if not used responsibly or you lack discipline, it’s possible to accumulate more debt during the draw period than you can reasonably afford to pay off.
Alternatives to home equity loans
If you aren’t sure a home equity loan is the right fit for your finances, consider these other options:
- HELOC: A HELOC is kind of like a home equity loan’s fraternal twin: They share plenty of the same characteristics, but they are not identical. A HELOC is a line of credit, which means you can access the money as you need it. HELOCs also have variable interest rates, so if prevailing market rates move up or down, your payments will change. This can create some challenges in terms of budgeting.
- Cash-out refinance: If you don’t want to take out a second mortgage to borrow money, you might opt to replace your existing mortgage with one larger sum of cash instead. A cash-out refinance allows you to borrow money based on your current equity, but it’s important to note that this process requires a lot of time and some hefty closing costs. Plus, you’ll be replacing your current mortgage with an entirely new set of terms. For example, if your current mortgage has a 5 percent interest rate, a cash-out refinance likely isn’t a good option right now, since mortgage rates have climbed above 6 percent.
- Personal loan: Personal loans are unsecured loans, which come with the benefit of not needing to put your house (or any other asset) on the line. However, they have significant drawbacks, too: Some personal loans have smaller maximum borrowing amounts of $35,000, and if you don’t have excellent credit, be prepared to pay far too much in interest. Some personal loans have excessively high interest that can stretch as high as 35 percent.
Home equity loans can be a useful option if you know how much you want to borrow and are more comfortable with a fixed monthly payment and fixed interest rate than a variable rate. However, think carefully about whether you’re comfortable using your home as collateral before proceeding with this type of loan, remembering that if for some reason you default, you could lose the property.