If you’ve been building your wealth and you’re currently seeking the financial freedom to start a business, pay for a college education, or purchase a second home, you might be considering a home equity loan. A viable option, home equity loans allow you to capitalize on the appreciation of your investment.
However, any financial decision is going to have its benefits and drawbacks. To that end, if you’re currently considering a home equity loan, we’ve built this guide to highlight the pros and cons of this lending medium.
What Is a Home Equity Loan?
The purpose of a home equity loan—also known as a second mortgage—is to help you convert your home equity into cash. The value of the home loan is determined by the equity you have in your house. Your home’s equity refers to how much of your house you actually own. Essentially, it’s the difference between the current value of your house and what you still owe on your loan balance to your mortgage lender.
Understanding the Basics of a Home Equity Loan
To help orient your perspective, here’s a quick primer on the essentials of taking on a second mortgage:
- It’s loaned at a fixed interest rate, with monthly payments.
- Home equity loans have a typical length of 5-15 years.
- You can get up to 85% of the value of your house.
- A home equity loan provides you with a lump sum of money that you can spend however you like.
To determine if you will be approved for a home equity loan, the lenders will look at:
- Your income
- Your credit score history
- The market value of your home
If your credit score rating is less than stellar, it might be difficult to acquire a home equity loan. Additionally, you may be asked to pay a higher interest rate. Now that you’ve got a primer on what home equity loans are, it’s time to start weighing the home equity loan pros and cons… as well as other options at your disposal.
What Are the Pros of a Home Equity Loan?
Let’s start with the good news. When it comes to the benefits of home equity loans, we’ve broken them down into three distinct components:
1. Fixed Interest Rate
Borrowers are often worried about interest rates on their loans, which can quickly become burdensome. Home equity loans are given out at a fixed interest rate—a monthly payment that will remain the same over the life of your home loan.
To that end, it’s important to understand the difference between a variable and a fixed rate:
- Variable Interest Rates – A variable interest rate structure fluctuates over time and could lead to a larger dent in your wallet.
- Fixed Interest Rates – A fixed interest rate structure offers a predictable, fixed monthly payment, allowing you to easily budget your month-to-month expenses.
2. Lots of Money in Your Pocket
Depending on the amount of equity in your house, home equity loans can give you a large lump sum of cash to use however you see fit. That means you can quickly have cash on hand, and lots of it. Money from a home equity loan can be used for many different purposes. If you’re wondering how to use home equity to your advantage, here are a few common uses:
- College tuition for yourself or another family member
- Wedding expenses
- Healthcare and expensive medical treatments
- Setting up an emergency fund
- Home improvement
- Buying a new car
- A relaxing vacation/travel expenses
- Starting your own business
No matter how you cut it, a home equity loan will put money in your pocket. However, with one of these loans, you can only access 80 to 85% of the money you’ve paid into your house.
3. Tax Write-Offs
If you choose to use your home equity loan to renovate your current home, buy, or build a new home, you may be able to write off the loan interest on your taxes.
Taxpayers can write off up to $750,000 of their home loan (referring to their existing mortgage and home equity loan) with this method, but they need to keep careful records to show the IRS that they spent the money appropriately. Unfortunately, people often think that the entire loan balance can be taken as a tax deduction.
Examples of this include:
- Remodeling your kitchen
- Putting an addition on your home
- Replacing your stairs with a new wooden deck
These tax write-offs exclude expenditures like:
- Buying a car
- Paying down credit card debt
- Funding a college education
Many of these expenditures are common reasons for taking a home equity loan, so consider your options wisely.
What Are the Cons of a Home Equity Loan?
Although the above might sound appealing, and there are significant benefits to a home equity loan, it’s not right for everyone. In which case, there are three home equity loan risks you should consider to determine if this loan is right for you.
1. A Loan Is Still a Loan
If you take a loan out, you will need to pay it back at some point in the future. Home equity loans are no different. If you choose to take out a home equity loan, your property is used as collateral. If you default on your loan, then you risk losing your property.
2. Home Equity Loans Have Hidden Costs
The loan could potentially cost you more than you’d expect. When you begin the process of taking a home equity loan, there may be extra fees tacked on to your loan that you are unaware of, such as:
- House appraisal fees
- Application and processing fees
- Lender fees
- Document fees
- Flood certificate
- Credit report fees
Combined, these fees can cost you upwards of $1,945!
3. A Lose-Lose Situation
If the real estate market ends up taking a downward turn, your house will not be worth what it once was. This can prove problematic should you want to sell your home, seeing as the total price may be below what you owe lenders.
A situation like this is known as being “underwater on your mortgage.”
In other words, the sale price won’t cover what you owe for the combined debt comprising your primary mortgage and home equity loan. In this scenario, you may need to convert what you owe into another loan, one that may have a higher interest rate.
Other Uses for Home Equity Loans
Home equity loans can be a valuable financial tool. Some possible uses for your loan aren’t necessarily pros or cons, they simply offer flexibility:
- Home Equity Investment – As one of the popular alternative ways to get equity out of your home, you have the option to take out cash to make property improvements. Because your home equity is at a lower interest rate, you can use that money for investment purposes with the expectation of a higher return. If you’re someone that likes to take highly leveraged risks, this is an avenue you can explore.
- Debt consolidation – Debt consolidation involves taking higher-interest debt and paying it back at a lower interest rate. You can combine your credit card debt, in addition to any car or student loans, and pull it into a lower rate. Taking this step should make your debt easier to pay off.
How a Sale-Leaseback Program Can Help
Ultimately, taking out a home equity loan can be a complicated process that requires stringent due diligence. If you’re not sure about a home equity loan, a sale-leaseback program can set you on the right path to your financial freedom.
When you’re considering a home equity loan, there are a lot of pros and cons to consider. Talk to a financial expert today to figure out if this solution is the best one for your needs or to determine if an alternative option might be best for you.