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.
It also has these pros and 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.
Pro #1: Home equity loans have low, fixed interest rates.
Compared with other forms of borrowing, home equity loans will almost always have some of the lowest interest rates no matter what is happening in the broader economy. Financial institutions don’t charge consumers as much to borrow when collateral secures the loan. That’s why mortgages, home equity loans, and auto loans tend to have lower interest rates than personal loans and credit cards , which are unsecured.
“A home equity loan can be bigger and cheaper than other types of funding,” said Andrina Valdes, executive sales leader and 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.”
Do you have enough equity to qualify? The lender will typically want you to retain 10 percent to 30 percent of your equity after the loan. Say you want to borrow $30,000. If your first mortgage balance is $250,000 and if your lender requires you to keep 20 percent of your equity, your home will need to be worth at least $350,000. 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.
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.
Home equity loans often have closing costs and appraisal fees, which you may be able to roll into your loan. When comparing 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 monthly payments.
Your credit score, other debts, and home equity loan amount will determine your interest rate. Low interest rates plus repayment periods of 10 to 30 years mean rock-bottom 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
Amount borrowed: $30,000
Interest rate: 6 percent
Monthly payment: $180
Total interest: $34,751
Since the Tax Cuts and Jobs Act of 2017, home equity loan interest is only tax deductible when you use it 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. (Related: Year-end tax-planning moves)
Pro #3: Home equity loan proceeds can be used for any purpose.
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. (If you’re thinking about using the money to finance your child’s education, read Families saving for college: A mutual approach.)
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.
Con #2: You have to borrow a lump sum.
With a home equity line of credit, 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.
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’re anticipating an economic downturn that could affect your income, how much should you borrow? What amount is enough? Too much? What monthly payment could you afford on a reduced income?
A home equity line of credit might seem like a better option 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 no higher than 50 percent, and a steady income. Some lenders have higher credit score requirements and lower debt requirements. If you want to borrow against your home because you’re not working and you’ve maxed out your credit cards, it’s probably too late. (Related: Improving your credit score: It pays off )
Home equity loans are often an appealing way to borrow
A home equity loan can lengthen the time until you own your home free and clear. Weigh the pros and cons 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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1 Calculated with https://www.bankrate.com/calculators/mortgages/loan-calculator.aspx.