Depending on your financial situation and goals, a home equity loan may be a good idea.
Building equity means you’re closer to paying off your mortgage and owning your home outright. But sometimes, you need to access some of the equity in your home. Is a home equity loan a good idea? That depends.
Because each family's financial situation is unique, Benzinga will give you the tools and considerations below to help guide your decision on the pros and cons of a home equity loan.
What is a Home Equity Loan?
A home equity loan is a way to tap into your home's equity in exchange for a lump-sum payment that can be used for any reason. Many utilize it to pay off unexpected debts or renovate their homes to increase value.
Equity is the asset value you've built in the home. It's the property's current market value minus the outstanding principal you owe on your mortgage. For example, if your home's current market value is $400,000 and your outstanding mortgage principal balance is $150,000, you have $250,000 in equity. A home equity loan can allow you to borrow some of that equity for other purposes.
Check out our handy guide for calculating home equity.
If you bought the home for $300,000 and have been paying the mortgage, interest, taxes and insurance, you could have paid down a significant portion of the loan. Additionally, if the property value increases, you'll gain equity you could tap into. You will have 100% of the home equity when you pay off the loan.
How Does a Home Equity Loan Work?
A home equity loan means you take a loan against part of the equity built in the home. It can be a way to leverage the value of your house to help with other financial goals, but you're essentially taking out a second mortgage.
Like a mortgage, you’ll find a home equity loan lender and go through the application process. This means you’ll have to prove that you can meet their eligibility criteria, so be sure you have a good credit score (at least 620, though higher scores will earn you lower interest rates), a decent debt-to-income ratio (43% or lower) and have enough equity in your house (at least 20%).
If approved, you’ll pay the closing costs and receive the funds a few days later. You’ll then be responsible for making monthly payments on the loan. Most home equity loans have fixed interest rates, meaning you’ll have consistent monthly payments.
“In an increasing rate environment, this is beneficial due to being able to lock in the rate,” says Sarah DeFlorio, vice president of Mortgage Banking at William Raveis Mortgage. “This type of loan is great for someone who needs to manage their repayment and is operating off a fixed income.”
While it may seem like "free" money, you're borrowing from your future self. For that reason, it’s not the best course of action for every homeowner.
Who is a Home Equity Loan Good for?
- Those planning home renovations that will increase their value
- Anyone seeking to consolidate high-interest debt with a lower interest rate
- Anyone looking to make a down payment on a second home
- Those seeking to cover major medical expenses or other large unexpected expenses
Benefits of a Home Equity Loan
Advantages of home equity loans include:
1. Flexibility in How Funds Are Used
With a home equity loan, you'll receive a lump sum and can use the funds for anything. For example, you could use them to renovate your home, pay for medical or college expenses or anything else.
2. Fixed and Lower Interest Rates
Home equity loans usually come with fixed interest rates. This allows you to plan your monthly payments and avoid unexpected changes in repayment terms. In addition, home equity loans usually have lower interest rates than personal loans or high-interest debt like credit cards. In addition, it can be easier to qualify for this type of loan than others.
3. Potential Tax Benefits on the Interest Paid
Taking out a home equity loan has some minor tax benefits. Generally, interest payments are tax-deductible, leading to possible savings at tax time. However, getting a loan for the tax benefits is never worth it.
4. Access To a Large Sum of Money Upfront
Another major advantage of home equity loans is access to a lump sum up front. If you need a lump sum for home renovations, college tuition, medical expenses or other costs and don't have other savings, a home equity loan can help.
5. Improves Home Value Through Renovations and Repairs
If you use your home equity loan to renovate or repair the property, you could increase the home's value. From replacing siding or a kitchen remodel to less-glamorous renovations like entry or garage door replacements or an HVAC conversion, you could recoup the value invested in the home and more when you sell.
Renovations aren't guaranteed to pay off, and some local market research or speaking with a real estate agent can give you an idea of whether the renovation is worth the cost.
Learn more about home equity loans for remodeling.
Who is a Home Equity Loan Bad for?
- People who can’t afford to make the monthly payments
- Those who have a well-funded savings account
- People who have nearly paid off their home (consider a personal loan instead)
- Those worried about losing their home
Risks of a Home Equity Loan
While there are major advantages to home equity loans, they come with some serious risks you should be aware of, including:
1. Risk of Losing Your Home if Unable to Repay the Loan
No. 1 on any list of cons of a home equity loan is that you could lose your home. While the chances are small, you risk losing your home if you face financial hardship and can’t make regular repayments on both the home equity loan and your primary mortgage.
The primary mortgage and the home equity loan place liens on the home, so the lender can foreclose on it if you fail to make payments.
2. Closing Costs and Fees Can Be Expensive
A home equity loan still comes with closing costs, typically between 3% and 6% of the loan value. In addition, closing costs can be related to fees, which is a disadvantage of home equity loans. Fees vary widely from lender to lender, which is why it's important to shop around before deciding on a lender. Lenders could charge $1,500 or more or as little as $200 in fees.
3. Requires High Equity
You'll need a minimum of 20% equity in the home, but ideally, you'll need higher equity. Some lenders may allow you to take a loan with 15% equity, but you will need a solid credit score and an acceptable debt-to-income (DTI) ratio. For most homeowners, it takes around five to 10 years to build up 15% to 20% of home equity. Even if you have higher equity, you'll lose that equity when you take the loan.
4. Need a Good Credit Score
You need a good credit score to qualify for a home equity loan. While many lenders will accept a credit score of 620-plus, a score of 700-plus can lead to lower interest rates and overall lower costs. Paying higher interest rates because of a lower credit score rate can be a disadvantage of home equity loans.
5. Can Lead To More Debt if Not Managed Carefully
Using a home equity loan to take a vacation, buy a car or cover another expense you could save for over time can put your long-term financial goals at risk. If you don't carefully manage debt and take equity out of your home to, for example, buy new furniture and a TV, it can feel fantastic in the short term. But as you pay off the loan, you're spending money that could work for you in retirement savings or investment opportunities.
The Bottom Line
A home equity loan might be a good idea to tap into your home’s equity. Here are a few things to keep in mind:
- Your house secures a home equity loan, so not making payments could result in foreclosure
- You’ll get a lump-sum payment
- Interest rates are fixed
Why You Should Trust Us
Benzinga has offered investment and mortgage advice to more than one million people. Our experts include financial professionals and homeowners, such as Anthony O’Reilly, the writer of this piece. Anthony is a former journalist who’s won awards for his coverage of the New York City economy. He’s navigated tricky real estate markets in New York, Northern Virginia and North Carolina.
For this story, we worked with Sarah DeFlorio, vice president of Mortgage Banking at William Raveis Mortgage, a Northeast-based mortgage lender and broker.
Frequently Asked Questions
Is a home equity loan a good idea to pay off debt?
A home equity loan isn’t always good for paying off debt. However, replacing higher-interest debt with lower-interest debt could help you pay off the debt faster.
Does a home equity loan hurt your credit?
It depends. Some lenders do a soft credit pull during the application process, while others perform a hard credit pull. The latter is more likely to hurt your creditworthiness. Some lenders may not report the loan to credit agencies, so ask when meeting with your lender.
What is the downside to a home equity loan?
The major downside to a home equity loan is that your house secures it, so not paying the loan back could result in foreclosure.
Sources
- Sarah DeFlorio, vice president of Mortgage Banking at William Raveis Mortgage
About Anthony O'Reilly
Anthony O’Reilly is an updates editor for Benzinga. He’s won numerous journalism awards for his coverage of the New York City economy and Long Island school district budgets.