Is a Home Equity Loan a Good Idea?

Building equity in your home is a wonderful accomplishment. It 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 the 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.  

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Understanding Home Equity Loans

A home equity loan is a way to tap into your home's equity. Equity is the asset value you've built in the home. It's the current market value of the property 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 in the home. A home equity loan is a way to reborrow some of that equity for other purposes.

If you bought the home for $300,000 and have been paying the mortgage along with interest, taxes and insurance, you could have paid down a significant portion of the loan. In addition, if the property value increases, you'll gain equity you could tap into. When you pay off the loan, you will have 100% of the home equity and own your home free and clear.

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 a new loan. 

With a home equity loan, you borrow a lump sum of money against the equity in your home and pay it back with fixed monthly payments over the life of the loan. 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.

When Is a Home Equity Loan a Good Idea?

A home equity loan sometimes can be a good idea. Because a home equity loan allows you to borrow a lump sum against the equity in the home, it can help in certain cases. For example: 

• If you're planning home renovation projects that should add value to the home 
• To consolidate high-interest debt with a lower interest rate 
• To take funds for the downpayment of a second home
• To fund education expenses
• To cover major medical expenses or other large, unexpected expenses 

When Should You Avoid Home Equity Loans?

A home equity loan is not a good idea if it will place too much financial burden, increase your debt-to-income ratio above 43% or cause other financial strain. If it only serves to shift debt around, it only makes sense if you can secure a significantly lower interest rate. 

• If your monthly debt payments would exceed 43% of your monthly income or you cannot comfortably repay the loan, don't take it.
• If you can fund the project another way, such as from savings or a payment plan with a 0% annual percentage rate (APR), consider that. 
• If you have nearly paid off your home in full, consider paying it off and taking a personal loan instead. 
• If you're worried about losing your home, don't take on additional debt.

Pros of Home Equity Loans

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 expenses, pay 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. In general, the interest payments are tax-deductible, leading to possible savings come tax time. However, it's never worth getting a loan for the tax benefits alone. 

4. Access To a Large Sum of Money Upfront

Another major advantage of home equity loans is access to a lump sum upfront. 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 make renovations or repairs to 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.

Cons of Home Equity Loans

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, if you face financial hardship and can’t make regular repayments on both the home equity loan and your principal mortgage, you risk losing your home. 

Both the primary mortgage and the home equity loan place liens on the home so that the lender can foreclose on the property 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, a disadvantage of home equity. 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 a good to 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 will 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 you have a lower interest 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 another expense that 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. 

Alternatives to Home Equity Loans

Some alternatives to home equity loans may work for your situation. Consider a home equity line of credit (HELOC) or a cash-out refinance. Here's how each works. 

HELOC

A HELOC is an alternative to a home equity loan. Instead of receiving a lump sum, you'll be able to tap into your home equity when needed during a draw period. A HELOC draw period usually lasts up to 10 years before the repayment period starts. HELOCs typically have variable interest rates.

A HELOC can be a good alternative to home equity loans if you need funds over time. For example, if you're starting a long-term renovation project that will require funds over time, a HELOC may be a better choice than a home equity loan. You don't need to take out more than required at any time but have access to the funds when you need them. Compare HELOCs versus home equity loans.  

Cash-Out Refinance

A cash-out refinance happens when you take out a new mortgage and repay your existing mortgage. When you take the new mortgage, you'll have the option to take out some cash, making it a "cash out" option. With a cash-out refinance, you'll pay off all existing liens and related expenses and take a new mortgage while accessing some of the equity in your home. 

Find the Best Home Equity Loan Lenders From Benzinga’s Top Providers

Find some of the best home equity lenders from Benzinga's providers and compare rates here. 

Should You Take Home Equity Loan?

Whether a home equity loan fits into your financial goals depends on your situation. If your goal is to pay off your mortgage early or to retire early, a home equity loan usually isn't the best strategy. If you need a lump sum for home renovations or other major expenses, a home equity loan can make sense. Likewise, if you're working to consolidate high-interest debt, the home equity loan can help. To compare rates and consider options, you can find the best home equity loans.

Frequently Asked Questions