What Everyone Should Know About Home Equity Loan Pros and Cons

Homeowners everywhere are discovering how their home equity can be leveraged in various useful ways, including home equity loans and lines of credit.

However, before anyone decides to tap into the equity they’ve paid in their home, it’s a good idea to look into the pros and cons of home equity loans.

Why home equity matters

Whether you want to use the money to pay off debts, make home improvements, or cover big expenses, your home’s equity can be a powerful financial tool to pay for what’s needed.

In this article, we’ll discuss home equity loans—pros and cons to help you choose how to leverage your home equity.

What is a home equity loan?

A home equity loan allows you to borrow against your home’s equity—the difference between how much you have left to pay on your mortgage and your home’s current market value.

Home equity loans provide a lump sum you repay over a fixed term, typically with a fixed interest rate.

This type of loan is often called a second mortgage because your home secures it, similar to your primary mortgage.

Let’s look at an example

If your home is appraised at $419,300 (which aligns with the national average for previously owned homes), you still owe $250,000 on your mortgage.

This scenario leaves you with $169,300 in equity. You can leverage this equity as collateral to obtain a loan, which can then be utilized to consolidate and pay off other high-interest debts, such as credit cards or personal loans.

Home equity loan vs. home equity line of credit (HELOC)

Both products use your home equity to provide the additional funds you need for various purposes. The difference is that a home equity loan pays out your equity in one lump sum to be paid back.

With a HELOC, you’re approved for a specific credit limit, depending on your equity, that you can draw on as needed during the draw period.

The draw period can last 5-10 years, during which you can pull from the funds, and then you typically have 10-20 years to repay it.

The pros of a home equity loan

1. Lower interest rates: One of the most popular benefits of a home equity loan is that it offers lower interest rates than most other loans, including credit cards, personal loans, and student loans. Because your home secures the loan, lenders can provide more favorable rates, resulting in substantial savings, especially if you use the loan to pay off high-interest debt.
2. Fixed interest rate and predictable payments: Home equity loans usually have a fixed interest rate, meaning your monthly payments remain consistent throughout the loan term. This predictability can simplify budgeting, as you’ll know exactly how much you must pay each month without worrying about interest rate fluctuations.
3. Access to a large sum of money: Home equity loans let you borrow a substantial amount because they are based on the equity in your home. This can be a huge plus if you have to cover major expenses like home renovations, medical bills, or consolidating debt. Access to a lump sum can help manage costs that might be difficult to manage with savings or other types of loans.
4. Potential tax benefits: If you use a home equity loan to improve your home or for certain other expenses, you can deduct the interest you pay from your taxes. Tax laws can change, and only some are eligible for this deduction, so it’s a good idea to talk to a tax advisor to see if it applies to your situation.
5. No restrictions on fund use: Unlike some loans with stipulations on spending, home equity loans offer flexibility. Once approved, you can use the funds for almost any purpose, such as paying for education, starting a business, or taking a vacation.

The cons of a home equity loan

Home equity loans can make the equity you’ve built work for you. However, there are drawbacks to this loan.

Risk of foreclosure

One major consideration of getting a home equity loan is that your home is at risk of being foreclosed if you can’t make the payments.

Before you borrow money, it’s vital to consider whether you can afford to pay back the loan and have a good plan for making the payments.

Fees and closing costs

When you take out a home equity loan, you may have to pay extra fees like closing costs.

These costs can often amount to 2- 5% of the loan amount, including fees for property appraisal, loan processing, and title searches.

Consider these extra costs when deciding if a home equity loan is right for you.

Reducing your home’s equity

When you take out a home equity loan, you borrow against your home’s value, reducing your equity.

This can be a disadvantage if you plan to sell your home soon or if property values decline, potentially leaving you “underwater” on your mortgage.

Long-term commitment

Home equity loans usually have long repayment periods, ranging from 5 to 30 years. This means you can have lower monthly payments and be in debt for a long time.

Impact on credit score

Applying for a home equity loan triggers a hard inquiry on your credit report—temporarily causing a drop in your credit score.

Additionally, taking on significant debt can raise your debt-to-income ratio, which might impact your ability to secure other loans in the future.

However, consistently making on-time payments can help improve your credit score.

Is a home equity loan right for you?

Deciding whether to take out a home equity loan depends on your financial situation, goals, and risk tolerance.

Here are key considerations to help you determine if a home equity loan is the right choice:

Financial stability

• Make sure you have a steady income and a clear repayment plan.
• Consider whether you could still make payments if your financial situation changes, like in a job loss.

Loan purpose

• Determine how you’ll use the funds.
• A home equity line of credit might be better if you’re unsure how much you’ll need for home improvement projects since you can draw as needed.
• Both home equity loans and HELOCs can consolidate high-interest debt.
• For discretionary spending, like a vacation, consider the risks carefully.

Long-term goals

• Assess how the loan aligns with your long-term plans.
• Borrowing against your home’s value may not be ideal if you’re planning to sell your home or need to preserve equity.

The pros and cons of home equity loans: Is it right for you?

Home equity loans offer benefits like lower interest rates, predictable payments, and access to large sums of money.

However, they also come with risks, such as the potential for foreclosure and long-term debt obligations.

Home equity lines of credit offer many of the same benefits as a home equity loan but offer more flexibility.

HomeEQ specializes in helping borrowers access their home equity. See for yourself with our easy-to-use digital application and start putting your equity to work today.