June 02, 2021 | home-buying
The Pros and Cons of a Home Equity Loan
One of the benefits of homeownership is the ability to tap into your home’s value and turn it into cash. With a home equity loan, homeowners can borrow against the equity they’ve built up in their property and use the money for things like home improvements, education expenses, debt consolidation, and more.
If you’re considering using your home as collateral to get funds, you’ll want to be sure you know about some of the perks— as well as the dangers— of the home equity loan.
Pros of a Home Equity Loan
Home equity loans come with some notable advantages. The following are some of the reasons why borrowers choose them over other types of loans.
1. You can use the funds from a home equity loan for any purpose.
There are no set guidelines on what the money can and can’t be spent on.”
What a home equity loan is used for is up to you. There are no set guidelines on what the money can and can’t be spent on. Typically, however, people choose to use home equity funds on larger expenses, since financial institutions typically have a minimum loan amount around $25,000.
Some common ways that people use their home equity loan include:
- Home improvements: Could your house use a few upgrades or remodels? A loan can give you the funds to complete those much-needed projects and home repairs.
- Medical expenses: Unexpected medical emergencies can leave people thousands of dollars in debt. A loan will allow you to pay these off and avoid being sent to collections.
- College expenses: If you’re wanting to go back to school to further your education or have a child about to go off to college, a home equity loan can be a relatively low-cost way to pay for those expenses.
- Debt consolidation: Do you have other debt on cards and loans with higher interest rates? Pay off things like credit cards and personal loans with your home’s equity. Consolidating your debt with a lower interest rate loan can save you in the long run and make paying your bills straightforward.
- Start a business: For those looking to turn a profitable side-hustle into a full-time gig, a home equity loan can give you the capital you need to get your business off the ground.
While there are certainly unwise ways to use your funds, you have the freedom to use them as you please.
2. Interest rates are fixed and often lower than other financing options.
Because your loan is secured with your house, lenders can offer you lower interest rates than they can with other forms of financing like personal loans or credit cards. They also have a fixed interest rate, meaning you don’t have to worry about skyrocketing rates over time.
3. A home equity loan is easy to qualify for and has fewer fees.
While you’ll have to meet certain criteria like a good credit score, a low debt-to-income ratio, and equity requirements, a home equity loan is still relatively easy to qualify for since it is secured with your house.
Additionally, a home equity loan is a great way to avoid expensive closing costs. Some lenders will only charge a low, flat fee at closing. However, it always helps to do some research, because some financial institutions charge 2% to 5% of the total loan amount. Comparing lender rates and fees can save you thousands upfront and over the course of the loan.
4. You could benefit from some tax deductions.
If you’re using the money to make improvements to the home that is securing the loan, you may qualify for tax benefits. The IRS says that the interest paid on a home equity loan is tax-deductible if it is used to “buy, build, or substantially improve” upon the home.
Keep in mind that you can only deduct interest up to $750,000 of residential loans and the improvements must be made to the house on which the loan is taken out. While you can certainly use the equity of the home you live in to make improvements to a rental property, you can’t deduct the interest.
Cons of a Home Equity Loan
While there’s plenty to be excited about, it’s also important to be aware of the downsides to a home equity loan.
1. A home equity loan uses your home as collateral.
Using your home to secure a loan means lower interest rates, but it also puts your home at risk of foreclosure. If you are unable to make payments, the bank has a right to seize your home and sell it to recoup their loss. It’s important to ensure that you can make your payments, even if unexpected expenses arise.
A home equity loan is still debt.”
2. You are taking on more debt.
Though it may be cheaper than other types of borrowing, a home equity loan is still debt. If you are still making your first mortgage payments on your house, be sure that you have the means to add another monthly payment on top of your original one.
The higher debt-to-income ratio that comes with taking on another home loan can also prohibit you from qualifying for other loans if you are planning to make another large purchase soon.
3. If the market crashes, you can find yourself underwater.
In an unfortunate scenario, you could find yourself underwater with a home equity loan. If you take out a large loan and the housing market crashes or something causes your home’s value to drop unexpectedly, you may actually owe more on your house than it’s worth. Having an underwater mortgage or loan can prevent you from selling your home unless you have the money to pay the loss.
Is a home equity loan a good idea?
Like any loan product, there are pros and cons of a home equity loan. They offer flexibility at a low cost, which are two qualities that make them attractive to many borrowers. However, it’s important to remember that you have more than your credit on the line with this loan— you are also putting your home at risk. But, if you are confident you’ll be able to repay the money, a home equity loan may be the perfect financial solution for your situation.
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