One of the benefits of homeownership is being able to tap into the equity in your property and use it as collateral for a loan when money is needed to pay for major expenses such as home improvements or debt consolidation. Funded in a lump sum and paid back over five to 30 years at a fixed interest rate, home equity loans can be a good choice for these types of large cash needs.
However, there are also some drawbacks to consider before proceeding with a home equity loan. Here are the pros and cons of home equity loans.
Key benefits of home equity loans
Those who get home equity loans may find there are several advantages versus other forms of borrowing.
Unlike a home equity line of credit (HELOC), which comes with a variable interest rate that can increase unexpectedly at any time, the interest rate on a home equity loan is fixed for the life of the loan.
“When you take out a home equity loan, right from the start, you will know exactly how much you’ll have to pay back each month and what the interest rate will be,” says Sam Eberts, junior partner with financial services firm Dugan Brown.
Lower interest rates
In addition to offering a stable interest rate, because home equity loans are secured by your property they typically offer a lower rate than unsecured forms of borrowing such as personal loans or credit cards.
“While you may pay closing costs or other fees, it’s an inexpensive alternative to an unsecured loan,” says Laura Sterling of Georgia’s Own Credit Union.
Long repayment terms
The repayment terms on home equity loans can be as long as 20 years. This fact, coupled with lower interest rates than unsecured loans can translate into a very affordable monthly repayment installment.
Possible tax-deductible interest
Another potential benefit of home equity loans is the tax write-off. The interest paid on a home equity loan may be tax-deductible up to $100,000 if you use the money to substantially improve the property used to secure the loan, says Sterling.“Because there are limitations on what you can deduct, it’s always best to consult your tax advisor,” says Sterling.
Key drawbacks of home equity loans
While there are many benefits to using a home equity loan for significant expenses, you should also consider the downsides before taking out this type of loan:
- You could lose your home. Because your home is being used as collateral for the loan, if you default, you risk losing your home.
“If you fail to pay your home equity loan, your financial institution could foreclose on your home,” says Sterling. “Similarly, if your home value declines, you could owe more on your home than it is worth, making it hard to sell.”
- You’ll need good to excellent credit. While it’s true that home equity loans generally offer lower interest rates than unsecured loans or credit cards, the most competitive rates are awarded to borrowers who have good to excellent credit.
- You must have substantial equity in your home. Qualifying for a home equity loan generally requires having between 15 percent to 20 percent in equity in your property.
- If you sell your home, you’re responsible for the balance of the loan. A home equity loan is tied to your home. If you choose to sell the home, you will be required to pay off the loan.
“In many cases, you may be able to use the proceeds of your home sale to pay off both loans,” says Sterling. “However, if your home value decreases or you’re upside-down on your home, it could put you in an unfavorable financial situation.”
Who home equity loans are best for
In general, home equity loans are best for borrowers who need to cover major costs or purchases and who know up front exactly how much money will be needed. These types of loans are also a particularly good option for those seeking to make improvements to their home.
“If a remodel is done properly, the home’s value will increase above the loan amount, creating even more equity in the home,” says Steve Sexton, financial consultant and CEO of Sexton Advisory Group. “In addition, the borrower can write off the interest on their taxes because they used the proceeds to renovate their home.”
Home equity loans vs. HELOCs
Both a home equity loan and a home equity line of credit (HELOC) use your home as collateral when borrowing money. However, there are also many differences between these two financial products, making it important to do your research and understand which one is truly right for your needs and financial picture.
Home equity loan
A home equity loan is dispersed in a lump sum making it a good choice for those who know exactly how much they need to borrow. In addition, this option comes with a fixed interest rate for the life of the loan and fixed monthly payments, which can be a safer bet for those on a tight budget.
“Home equity loans give you the security of knowing your exact monthly payments,” says Sterling, of Georgia’s Own.
A HELOC is a revolving line of credit similar to a credit card. You can borrow from a HELOC as needed during its draw period, which usually lasts about 10 years. After that, you enter the repayment period.
There are various benefits to a HELOC including the fact that you are only responsible for repaying what is borrowed. HELOCs may be a good choice if you lack clearly defined borrowing needs or have costly, ongoing projects and will need to access cash over an extended period of time.
One of the most significant downsides of a HELOC however is that they come with a variable interest rate that can increase unexpectedly. “You could get stuck paying higher interest rates while still having to make your regular mortgage payment simultaneously,” says Eberts, of Dugan Brown.
In addition, if not used responsibly or you lack discipline, it’s possible to accumulate more debt during the draw period than you can reasonably afford to pay off.
Home equity loans can be a useful option if you know how much you want to borrow and are more comfortable with a fixed monthly payment and fixed interest rate than a variable rate. However, you should think carefully about whether you are comfortable using your home as collateral before proceeding with this type of loan remembering that if for some reason you default, you could lose your home.