Imagine having a hidden treasure beneath your feet that only grew in value over time. In a way, your home equity is exactly that—a store of value built upon your diligent mortgage payments and dutiful care of the place you call “home.”
Yet for homeowners seeking to tap into this store of value, it’s not quite as simple as cashing out on a pot of gold. A number of questions arise.
Is a home equity loan a good idea in the first place?
What are the home equity loan pros and cons I need to know?
Let’s dive into the specifics of home equity loans and find out if this option is right for you.
What is a Home Equity Loan?
When homeowners are in need of funds, one loan option they often consider is a home equity loan.
Colloquially known as a second mortgage, a home equity loan allows you to borrow against the equity you’ve built in your property through mortgage payments. They’re a common way to get equity out of your home without refinancing.
That’s the simple explanation, but how specifically does it work?
How Does a Home Equity Loan Work?
As mentioned, home equity is a store of value built in your home, and can be calculated in two steps:
- Determine the current market value of your home.
- Subtract the outstanding mortgage still owed on it. The remaining amount represents your current home equity.
A home equity loan works by leveraging that equity as collateral to borrow a lump sum of money. This loan is then repaid over a fixed repayment term, and typically with a fixed interest rate.
The Advantages of Home Equity Loans
For homeowners seeking to leverage the power of their home’s value, home equity loans can be an attractive option. There are many reasons for a home equity loan. As we weigh the home equity loan pros and cons, let’s first take a look at a few of the specific advantages this financial tool can offer:
Lower Interest Rates
A key advantage of home equity loans is the potential for lower interest rates compared to other forms of credit, such as credit cards. Since the loan is secured debt by the value of your home, lenders usually offer competitive mortgage rates averaging at 5% to 6%, compared to the average credit card’s 15%.1
Fixed Interest Rates
Unlike other types of loans, where interest rates fluctuate over time (a variable interest rate), home equity loans offer the stability of a fixed rate. This has several advantages of its own:
- Consistency throughout the loan term
- Easier financial planning
- Protection from future rate increases
This stability can be particularly beneficial when planning for long-term expenses or making other major financial decisions.
In certain cases, the interest payment on a home equity loan may be tax-deductible. Per current IRS guidelines, home equity loan funds used to “buy, build, or substantially improve your home” enjoy tax-deductible interest.2 Of course, when it comes to taxes, it’s always good to double-check the implications with a professional.
Funding Major Expenses
Home equity loans can be an excellent resource for financing significant expenses such as:
- Building an emergency fund
- Paying off medical bills or other unsecured debt
- Purchasing or repairing a major appliance
The lump sum nature of a home equity loan provides borrowers with the necessary funds upfront to address these financial needs, then allowing the repayment term to be made little by little with low interest rates.
The Risks of Home Equity Loans
While home equity loans offer numerous advantages, it’s also important to consider the potential risks involved. Here are a few downsides to consider before applying for a home equity loan.
Risk of Losing Your Home
When obtaining a home equity loan, you are using your property as collateral. This means that failure to repay the loan as agreed can result in foreclosure, putting you at risk of losing your home. This is particularly concerning if you have bad credit.
Whereas options like a home equity line of credit (HELOC) allow you to draw funds as needed, home equity loans provide a lump sum upfront. This lack of flexibility may not be the best option for homeowners who require ongoing access to funds.
Potential for Negative Equity
Equity is tied to the value of your home. So if property values decline, there is a risk of owing more on your loan than the home is worth. This situation, known as negative equity, can make future borrowing options (such as a remortgage) difficult since you need to make up the difference between what you owe and the declined value of your home.3
The Burden of Two Mortgage Payments
A home equity loan adds an additional monthly payment to your financial obligations. While it provides access to funds, it’s important to understand that it increases overall debt and interest payments. This can put extra strain on the budget, especially if you’re already struggling to meet existing mortgage payments.
When is a Home Equity Loan a Good Idea?
After examining the home equity loan pros and cons, it becomes evident that this financial tool can be advantageous for certain homeowners in specific situations.
To help answer the question of is a home equity loan a good idea in your case, let’s explore some specific scenarios where its pros truly shine.
If you find yourself juggling multiple high-interest debts, such as credit card balances or personal loans, a home equity loan can provide a viable solution.
By consolidating your debts into a single loan with a lower interest rate, you can streamline your monthly payments and potentially save money on interest in the long run.
If you have home improvement projects in mind, a home equity loan can be a valuable resource. This could include projects like:
- Renovating your kitchen
- Adding an extra room
- Upgrading your landscaping
Using your home’s equity in this way can provide the necessary funds to enhance your living space and potentially increase the value of your property.
In such a scenario, you could also potentially use a home equity loan to buy another house.
Whether it’s college tuition or vocational training, if you’re seeking to finance education expenses for yourself or a loved one, home equity loans can offer a cost-effective option compared to student loans or other forms of borrowing.
When is a Home Equity Loan Not a Good Idea?
While a home equity loan can be beneficial in some circumstances, it may not be the right choice for everyone.
To ensure you make informed financial decisions, let’s explore some situations where a home equity loan may not be the best option.
Using Funds for Non-Essential Expenses
It would not be prudent to use a home equity loan to fund non-essential expenses, such as:
- Luxury vacations
- Extravagant purchases
- Expensive and depreciable assets, like a boat
Again, a home equity loan is access to funds that will eventually need to be repaid. So it’s important to use borrowed funds responsibly and consider the long-term financial impact these purchases might have.
If You Plan to Move Soon
If you have plans to sell the property in the near future, taking out a home equity loan may not be advisable. The costs associated with obtaining the loan, including closing costs and fees, may outweigh the benefits. This is especially true if you’re not able to repay the loan before you move—you could end up saddled with three separate mortgage payments.
If You Cannot Afford Two Mortgage Payments
Considering the potential risks involved, it is essential to assess whether you can comfortably afford the additional mortgage payment required by a home equity loan. Falling behind on payments can lead to financial hardship and even the risk of losing your home, especially if you’re dealing with bad credit.
Alternatives to Home Equity Loans
While a home equity loan is certainly a viable loan option for converting your home equity, it’s always important to explore alternative avenues that may better suit your financial needs.
Before settling on a home equity loan, consider whether these alternatives might be worth further research.
Home Equity Line of Credit (HELOC)
When comparing a home equity loan vs HELOC, there are key facts to consider. Similar to a home equity loan, a HELOC allows borrowers to access funds based on the equity in their home. However, instead of receiving a lump sum, borrowers can draw and repay funds as needed during a specified draw period, providing increased flexibility. HELOCs often come with a variable interest rate.
Whether you’re navigating the waters of securing a HELOC with bad credit or bouncing back after receiving a denied HELOC application, always remember that there are resources available to help you move forward.
Similar to a home equity loan, cash-out refinance offers a lump sum based on your equity. Here’s how it works:
- It replaces your existing mortgage with a new one that has a higher principal balance.
- The difference between the new mortgage loan amount and your existing mortgage balance is then converted into cash.
This option can be advantageous for homeowners with substantial equity in their homes, as it allows for immediate access to funds and the potential to secure lower interest rates.
Personal Loans and Credit Cards
For smaller, everyday purchases, consider whether or not a personal loan or credit card would be a better choice.
Although credit card interest rates may be higher, keep in mind that a home equity loan is a large lump sum. So even if the rate is lower, you may be paying more on interest overall, depending on your purchases.
The Sale-Leaseback: A Different Option
Another alternative to consider is a residential sale-leaseback program. With a sale-leaseback, also known as a rent-back agreement, you can sell your home to a private company and then lease it back as a renter. This allows you to convert your home equity into immediate, debt-free cash without having to leave your home.
Comparing Sale-Leaseback Programs to Home Equity Loans
There are many sale-leaseback benefits, and a sale-leaseback program is similar to a home equity loan in that both are financial tools that allow homeowners to immediately harness the value of their home equity through a lump sum payment.
Although similar, they do have a few key differences, such as:
- Repayments – Home equity loans come with interest rates that chip into the value you can extract from your equity. A sale-leaseback converts equity straight to cash, meaning there is no repayment period or interest.
- Ownership – A home equity loan leverages the value of your home, with you as the owner. A sale-leaseback transfers ownership to the company that purchases your home, meaning you can live there freely under the rental agreement without having to worry about major repairs, property taxes, or homeowners’ insurance.
Overall, a sale-leaseback is a unique alternative for those that want to remain in their home but require immediate conversion of their equity.
Even if you have bad credit, there are loan options available for you. With careful planning and understanding of the credit score requirements, you can explore options like a home equity loan with bad credit or a reverse mortgage.
So, is a home equity loan a good idea? Before deciding whether it’s the right choice for you, carefully consider the pros and cons. Evaluate your financial situation, goals, and risk tolerance to determine if a home equity loan, or an alternative option like a sale-leaseback, best meets your needs.
There are many ways to unlock your home’s equity, so consult with financial professionals and lenders to explore all available options. Whatever your financial goals, by leveraging your home’s hidden treasure in the most strategic and responsible way, you unlock a powerful tool to help you every step of the way.
This article is published for educational and informational purposes only. This content is based on research and/or other relevant articles and contains trusted sources, but does not express the concerns of EasyKnock. Our goal at EasyKnock is to provide readers with up-to-date and objective resources on real estate and mortgage-related topics. Our content is written by experienced contributors in the finance and real-estate space and all articles undergo an in-depth review process.
- Lend EDU. Should You Use a Home Equity Loan or Line of Credit to Pay Off Credit Card Debt? https://lendedu.com/blog/home-equity-loan-line-of-credit-to-pay-off-credit-card-debt/
- IRS. Publication 936. https://www.irs.gov/publications/p936
- Nerdwallet. What to do about negative equity: Know your options. https://www.nerdwallet.com/uk/mortgages/what-is-negative-equity/