If you’re looking to take out a loan to pay for something large like home improvements or your child’s college education, you may be weighing your options. And if you’re a homeowner, a home equity loan may be at the top of your list.
But is borrowing against your home’s equity actually a good idea? In this article, we’ll break down what homeowners should consider before taking out this type of loan.
What is a home equity loan?
A home equity loan is money borrowed against the equity you have in your house. This type of loan is paid back over a fixed period, usually between five to ten years. In some cases, the loan term may be stretched out up to 30 years. Interest rates are also fixed.
What are the pros and cons of home equity loans?
Though they come with some unique benefits compared to personal loans, there are also some risks of home equity loans to consider. Here’s how the pros and cons stack up against each other.
You can use a home equity loan for anything. While people often use home equity loans to pay for things like home improvements, education, or unexpected medical expenses, you are free to use the funds however you see fit.
You must meet credit requirements. To qualify for a home equity loan, your financial institution will want to see a good to excellent credit score.
Your interest payments may be tax-deductible. If you’ve used your loan to “buy, build, or substantially improve” your home, the interest payments may be tax-deductible, lowering your yearly tax burden.
You must have equity in your home. Your loan size will be limited by the equity you have in your house. Additionally, Texas laws prevent homeowners from tapping into more than 80% of your home’s equity— even if you own your home outright.
Interest rates are typically lower than other types of loans. Because home equity is used as collateral to secure the loan, the lender assumes less risk, which translates to a lower interest rate and better terms for borrowers.
You might have two house payments per month. If you’re still paying off your home mortgage balance, a home equity loan adds another house-related payment each month.
Your home is collateral. Though it is rare that people lose their home due to a home equity loan default, it is possible.
Questions to Ask Yourself Before Taking Out a Home Equity Loan
To ensure that you don’t put yourself in a financial bind, ask yourself the following questions before taking out a home equity loan.
1. How much debt do I already have?
First, think about how much debt you currently have. Not only will it be difficult to even obtain a home equity loan if you have too much debt, but it can also put you in financial peril.
Most financial experts will recommend keeping your debt-to-income ratio under 36%. You can calculate your debt-to-income ratio by dividing your monthly debt payments by your monthly income and multiplying the result by 100. If your debt-to-income ratio is more than 36%, consider paying off your existing debts before you take on another loan.
2. Can I afford the monthly payment?
If you don’t have a large amount of debt, next ask yourself if you can afford monthly payments. An online calculator or lender can help you determine how much your monthly payments will be based on how much you want to borrow and the interest rate you can get.
3. Could I still make the loan payments if an unexpected expense comes up?
So you can make the payments now, but would that change if you ran into unexpected financial difficulties such as a medical emergency or losing your job? Do you have an emergency fund large enough to cover payments until you could get back on your feet again?
Make sure that if you can afford the monthly payments, you’re not just squeaking by. Give yourself some wiggle room for financial emergencies.
4. Would another kind of loan make more sense for my intended use?
Though you can use your equity for anything, it doesn’t mean you should. There are good reasons to use a home equity loan and there are not-so-good reasons.
Some people try to finance things like a new car with a home equity loan. This is a bad idea for several reasons. First of all, depending on your credit score, you could get a much lower rate on a car loan – especially if a dealer is running a special on a model they are trying to move off the lot. Second, home equity loans have much longer payment periods than car loans do. You don’t want to be paying for your car 10 years from now! And finally, vehicles mostly lose value while homes mostly increase in value. You don’t want to finance a depreciating commodity with an appreciating one.
Always ask yourself if another type of loan would make more sense for your intended use. If you aren’t sure, do some research online or reach out to a local lender for guidance.
5. Would I benefit more from a home equity line of credit?
A home equity line of credit (HELOC) is similar to a home equity loan but with several notable differences. Like a home equity loan, a HELOC is borrowed against the equity you have in your house.
However, instead of getting funds in one lump sum, you draw funds as you need them. The benefit to this is that you only have to pay interest on the amount you actually use— not the entire amount that you were approved for. This can be useful in situations when you aren’t quite sure exactly how much you’ll need or when you’ll need it.
Choose Your Loan Carefully
Taking out a large loan is an important decision that requires careful consideration— especially when your home is on the line. A home equity loan can be a great financial tool if you don’t have a lot of existing debt and have the ability to pay it off.