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Many homeowners don’t have a lot of extra cash saved up, but they do have a lot of home equity. Equity is the difference between your home’s current appraised value and your mortgage balance. If your home appraises for $400,000 and you owe $200,000, your equity is 50 percent.
So, for homeowners who need cash, a home equity loan can be a smart choice. It’s generally faster, easier, and less expensive than a cash-out refinance, and it doesn’t restart the clock on paying off your home. Note that a home equity loan is different from a home equity line of credit (HELOC).
A home equity loan has these pros and cons:
Pros
Cons
- Your home secures the loan, so your home is at risk.
- You have to borrow a lump sum.
- You can’t get a home equity loan with too much debt or poor credit.
Here are some of the main pros and cons of home equity loans in more detail.
Pro #1: Home equity loans have low, fixed interest rates.
Compared with other forms of borrowing, home equity loans usually have relatively low interest rates no matter what is happening in the broader economy. “A home equity loan can be bigger and cheaper than other types of funding,” said Andrina Valdes, COO of Cornerstone Home Lending. “It’ll typically come with a lower interest rate than you’ll get when taking out a personal loan or a line of credit.”
Financial institutions don’t charge consumers as much to borrow money when collateral secures the loan. And because your home is such a valuable asset, you may be able to borrow quite a bit, depending on how much equity you have.
The lender will typically want you to retain 10 to 30 percent of your equity after the loan. Another way of looking at this is that you can’t borrow more than 70 percent to 90 percent of your home’s value with your first mortgage and home equity loan combined.
Say you want to borrow $30,000 and your lender requires you to keep 20 percent of your equity. If your first mortgage balance is $250,000, your home will need to be worth at least $350,000. Your first mortgage combined with your home equity loan will total $280,000, or 80 percent of $350,000.
Home equity loans typically have a fixed interest rate, giving borrowers predictable monthly payments. Home equity lines of credit, by comparison, often have a variable interest rate. The variable rate may be lower at the beginning, but in the long run, your monthly payments and your total borrowing costs will be unpredictable. They could go up significantly under economic conditions that push interest rates higher. (Learn more: How interest rates work)
Home equity loans often have closing costs and appraisal fees, which you may be able to roll into your loan. When considering offers from different lenders, make sure you’re comparing the total cost of each loan by looking at the annual percentage rate. APR includes both the loan’s interest rate and its fees. Some lenders offer home equity loans with no closing costs or fees while still offering competitive interest rates.
Pro #2: Home equity loans have low, predictable monthly payments.
Your credit score, other debts, and home equity loan amount will determine your interest rate. Relatively low interest rates plus repayment periods of 10 to 30 years can mean affordable monthly payments.
That said, the more years you take to repay your loan, the more interest you’ll pay. Consider these examples:1
10-year home equity loan
- Amount borrowed: $30,000
- Interest rate: 6 percent
- Monthly payment: $333
- Total interest: $9,967
30-year home equity loan
As you can see, the longer the loan term the greater the interest paid over time. Still, the ability to set a predictable schedule of payments is one of the advantages of a home equity loan that many homeowners find beneficial.
Pro #3: Home equity loan proceeds can be used for any purpose.
Since the Tax Cuts and Jobs Act of 2017, home equity loan interest is only tax deductible when you use the loan to substantially improve your main or secondary home. In addition, interest on home loan debt from all sources is not deductible to the extent that it exceeds $750,000 ($375,000 for married couples filing separately).
The interest you pay on a home equity loan for college tuition, medical expenses, debt consolidation, or another purpose is not deductible like it was in the past. However, if you use part of the loan for a nondeductible purpose and part of the loan for home renovations, you can still deduct the interest attributable to the part of the loan you spent on your home. (Related: Year-end tax-planning moves)
While the interest may not be deductible if you don’t use your loan for home improvements, many taxpayers stopped itemizing their mortgage interest anyway after the Tax Cuts and Jobs Act doubled the standard income tax deduction. So, if you want to use home equity borrowing to pay off high-interest debt or start a new career, it may make sense to focus on the low cost to borrow the money, not on the tax deduction you might be missing.
Now you know some of the biggest benefits of home equity loans. And these advantages of a home equity loan can be quite useful for a homeowner. However, no loan is without drawbacks. Consider these potential downsides and disadvantages of a home equity loan before you borrow.
Con #1: Your home secures the loan, so your home is at risk.
Foreclosure is possible if you can’t make your payments. You’ll want to carefully choose a loan amount, term, and interest rate that will let you comfortably repay the loan in good times and bad.
Still, even though your home secures the loan, lenders usually don’t want to foreclose. Foreclosure is expensive and doesn’t guarantee that the lender will recoup what you owe, especially if you’re carrying more mortgage debt than your home is worth. This can happen when homes lose value in a declining market.
When borrowers have payment trouble, some lenders are willing to work with them to modify or restructure a home equity loan. But you shouldn’t count on it, and you should know the worst-case scenario. (Related: Making sure your home improvement pays off)
Con #2: You have to borrow a lump sum.
With a home equity line of credit (HELOC), you can borrow smaller amounts as you need them and only pay interest on the money you truly need to borrow. With a home equity loan, you must choose a lump sum to borrow all at once and pay interest on the full amount. (Related: Home equity lines of credit: Pros and cons)
This aspect of home equity loans isn’t always a drawback. Let’s say you’re a homeowner building an addition to your house or remodeling your kitchen. You’ll know at the outset what your contractor is going to charge, and you can even add a cushion for potential overages. If you don’t spend it all, you can use the funds for something else or repay them early. But you should still borrow carefully.
“You could take out too much,” Valdes said. “With a larger loan amount, you might end up spending more on home repairs or improvements than intended.”
Now if you’re financing something where the costs are less clear, having one shot to decide how much to borrow can be a challenge. For example, if you want more cash on hand for a short-term financial setback, how much should you borrow? What amount is enough? Too much? What monthly payment could you afford on a reduced income? And should you be setting aside more cash in an emergency fund?
A HELOC might seem like a better option than a home equity loan here, but lines of credit can be revoked, as many homeowners learned the hard way during the Great Recession. A home equity loan gives you a more secure borrowing option if you’re willing to pay for it.
Con #3: You can’t get a home equity loan with too much debt or poor credit.
The thing about borrowing against your home is that it doesn’t work as an option of last resort. As with any loan, the lender wants to know you’ll be able to repay it. Just like when you took out your primary mortgage, you’ll typically need a credit score of at least 620, a debt-to-income ratio generally no higher than 36 percent to 43 percent depending upon the lender, and a steady income.
Some lenders have higher credit score requirements and lower debt requirements. If you want to borrow against your home as a stopgap because you’re not working and you’ve maxed out your credit cards, it’s probably too late. (Learn more: Improving your credit score: It pays off)
Home equity loans are often an appealing way to borrow
While relatively cheap, a home equity loan can lengthen the time until you own your home free and clear and, if things go south, put you at risk of losing your home. Weigh the pros and cons of home equity loans carefully, then get offers from several home equity lenders to see what your options are. If you need help making a decision, a trusted financial professional can help.
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This article was originally published in April 2020. It has been updated.
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1 Calculated with https://www.bankrate.com/calculators/mortgages/loan-calculator.aspx.