What are the Pros & Cons of Home Equity Loans?
A home equity loan, also known as a “second mortgage” is a means to access the cash value of your home’s equity, by borrowing against the amount of your home you’ve currently paid down. A home equity loan – along with a home equity line of credit (HELOC) and a cash-out refinance – are the main ways an individual can access the value of their current home without selling it. Each loan has its pros and cons, and understanding those difference is crucial to understanding which loan type makes the most sense for you to do.
Why Get a Home Equity Loan?
Before we break down the specifics of each loan type, let’s explain why someone would want to tap into their home’s equity.
Most individuals purchasing a home will buy one using a mortgage, meaning they pay a certain percent of their home’s value upfront (known as a down payment) and borrow the rest. The amount borrowed is then paid back in monthly payments, meaning the homeowner is essentially “buying” back a portion of their home’s equity every month.
While this is great for managing expenses, it can be tricky when funds are tight, as an individual may invest hundreds of thousands of dollars in an asset whose value they can’t access until they sell their home.
Home equity loans, lines of credit, and cash out refinances solve this problem. By allowing you to borrow against the amount of value you own in your home (typically up to 85% or 90%), these loan types give you a means to access your property value, while still maintaining ownership of your home.
Home Equity Loan Advantages
There are many advantages to accessing your home’s equity through a loan. We outline the main ones below.
1. Low Interest Rates. One of the big advantages of home equity loans compared to personal loans and credit cards is they carry substantially lower interest rates. By “securing” a loan by tying in a home as collateral, home equity loans reduce risk for lenders, which in turn translates to lower interest rates. The average APR for a home equity loan was between 4% and 7% last year – compared to 17.79% for credit cards.
2. Large Loan Amounts. Similar to low interest rates, home equity loans allow individuals to borrow a substantially higher amount than they would be able to with credit cards or personal loans – sometimes up to $750k. This makes these home equity loans invaluable for paying off large expenses, such as home improvement bills, medical bills, or consolidating higher interest debt – such as student loans and credit card debt – into one location with a a low rate
3. Fixed Interest Rates. This is probably the biggest advantage of home equity loans compared to HELOCs. Unlike HELOCs – which have adjustable interest rates – home equity loans have fixed rates, meaning you will pay the same amount monthly for the life of the loan.
This is a very important difference to know, as even though a home equity line of credit can often carry slightly lower interest rates than home equity loans, these rates are variable rates – meaning the amount you will pay is subject to change over time. This means a sudden spike in your rate (which typically happens when the economy is tightening) can leave you paying more than you bargained for – at a time when you need money most.
4. Tax Deductible Interest. If you use the funds from your home equity loan for home improvement, you are able to write off the interest from your loan in your taxes. Essentially meaning you can have a double-win by increasing the value of your home, and pay less taxes doing so.
Home Equity Loan Disadvantages
While home equity loans are very favorable loan vehicles relative to other types of loans, they have distinct disadvantages compared to HELOCs and cash out refinance – the other two means of accessing home equity. We compare some of the main reasons below.
1. Higher Closing Costs and Fees. Much like new mortgages, home equity loans can often carry a number of fees – including application fees, origination fees, and annual fees. These can be as high as 2%-5% of the loan amount. Home equity lines of credit tend to have slightly lower fees on average, with many having options to waive the fees if you are a member of the lending institution.
2. Lack of Flexibility. A home equity loan immediately provides the entirety of a loan upfront in a lump sum payment, and you pay interest on all of the unpaid balance. This differs substantially from a HELOC, which gives you no money upfront, and instead extends you a line of credit, allowing you to borrow as much or as little as you need – up to the specified credit limit. For instance with a HELOC, you could have a credit limit of $500k, but only borrow $100k as it’s needed, allowing you to avoid paying interest on the remaining available $400k.
3. Higher Interest Rates. Although marginal, a home equity loans will tend to have a slightly higher interest rate than an equivalent home equity line of credit – somewhere around 0.5% more. This can seem even greater as home equity lines of credit have introductory rates that are .05% to 1% lower than the standard rate, for the first 6 to 12 months. However, as these are variable rates, these lower rates can evaporate overnight if interest rates spike.
Things to Consider Before Getting a Loan
While there are a lot of financial incentives to borrowing against the value of your home, it’s a very large financial decision that should be taken seriously.
Before you make any decision on either a home equity loan or a HELOC, you’ll want to consider how much you’re borrowing relative to your income, and how much you’re borrowing compared to the value of of your home. These are known in the industry as your loan-to-income ratio and your loan-to-value ratio (or LTV).
Most home equity lenders will have internal applications which will prevent you from borrowing too high an amount (typically LTV ratios are not higher than 85%), however that doesn’t mean you still can’t get in over your head.
Home equity loans are typically for a large amount of money – minimum loans tend to be $25k or $50k – meaning monthly payments can be quite large. If your income situation is rocky, you’ll probably want to wait before committing to this loan.
That’s why it’s typically advised to not access your home equity, unless it’s for a means that will increase your cash flow.
- For instance paying off high interest student loans by accessing a lower rate loan is a smart financial decision as it reduces your interest payments.
Investing in your home’s value helps to increase its market value.
However borrowing $50k for a car would generally be considered a bad use of borrowing from your home’s equity (unless for instance, you were already going to buy that car in installments, and you can save money on interest this way).
Finally, once you do decide it’s a good time to tap into your home’s equity, you should always shop around with multiple home equity lenders for the best rate, and consider if you want a home equity loan or home equity line of credit.