The Pros and Cons of a Home Equity Loan

Homeownership comes with a lot of unique benefits. Many homeowners find that one of the best perks is the ability to tap into their 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.

But like most forms of lending, a home equity loan isn’t without its drawbacks. If you’re considering using your home as collateral to get funds, you’ll want to be sure to weigh the pros and cons before you sign on the dotted line.

To help you better understand the ins and outs of home equity loans, we’ve broken down the basics with the help of Amplify’s own Mortgage Loan Originator, Terry Council. 

What is a home equity loan?

Before we jump into the pros and cons of home equity loans, it helps to understand exactly how they work.

In short, a home equity loan allows you to borrow against a portion of the equity you’ve built in your home. 

“With a home equity loan, you’re using the equity you’ve built in your home as collateral to borrow a set amount of money,” Council explains. “You receive those funds upfront and then pay the loan back over an agreed-upon term.

Home equity loans typically come with a fixed interest rate and predictable monthly payments. If you still have a mortgage, the home equity loan generally becomes a separate payment in addition to your existing mortgage payment.

Home Equity Loan Pros and Cons at a Glance

Advantages of Home Equity Loans	Disadvantages of Home Equity Loans
Funds can generally be used for any purpose.	You’re taking on more debt, potentially on top of your existing mortgage.
Fixed interest rates make monthly payments predictable.	Closing costs and other loan fees may increase the cost of borrowing.
Interest rates are typically lower than unsecured options like personal loans or credit cards.	If your house value decreases, you may find yourself underwater.
Home equity loans are often easier to qualify for than other types of loans.	If you sell your home before the loan is paid off, the remaining balance generally must be repaid from the proceeds of the sale.
Interest may be tax-deductible when the funds are used for certain qualifying home improvements.

Pros of a Home Equity Loan

Home equity loans have a few features that make them an attractive option when you need to borrow a larger amount of money.

“One of the biggest advantages is that you’re borrowing against an asset you already own,” Council explains. “That can give you access to competitive rates, a fixed payment, and the flexibility to use the funds for whatever you need.”

Of course, those benefits should be weighed against the risks of borrowing against your home. But first, let’s take a closer look at what a home equity loan can offer.

1. You can use the funds from a home equity loan for any purpose.

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. That means your rate won’t change throughout the life of the loan, making your payments easier to plan for.

“The predictability of a home equity loan can be a big benefit for homeowners,” Council says. “You know what your payment is going to be each month so you can work it into your budget without worrying about your rate changing down the road.”

3. A home equity loan is easier to qualify for and has fewer fees.

Compared to other types of loans available to consumers, home equity loans are typically easier to qualify for.

“You’ll still have to meet certain criteria like a good credit score, a low debt-to-income ratio, and equity requirements,” notes Council. “But it’s usually easier to get approved for a home equity loan than an unsecured product like a personal loan.”

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 of dollars upfront and over the life 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” 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. You are taking on more debt.

Though it may be cheaper than other types of borrowing, a home equity loan is still debt— and debt secured by your house at that. 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.

2. Closing costs and other fees may apply.

While home equity loans often have lower fees and closing costs than unsecured loans, there are still going to be some costs associated with taking out this type of loan. It’s important to factor these costs in when weighing your options.

3. If the market crashes, you can find yourself underwater.

While Texas has some of the strictest home equity lending laws in the nation, it’s still possible to find yourself owing more on the house than it is worth. Council says this is rare thanks to the consumer protections that the state has, but it’s still something to keep in mind.

“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,” he explains. “Having an underwater mortgage or loan can prevent you from selling your home unless you have the money to cover the loss.”

4. Selling or refinancing can become more complicated.

Taking out a home equity loan doesn’t mean you’re stuck in your home until the loan is paid off. However, having another loan secured by your property can add another thing to think about should you decide to sell or refinance.

If you sell your home while you still have a balance on your home equity loan, that balance typically must be paid off at closing along with your primary mortgage. The money typically comes from the proceeds of the sale, which means you’ll walk away with less money in your pocket than you would have if you didn’t have the loan.

“You want to think about your future plans for the home, especially if there’s a chance you might sell in the next few years,” says Council. 

Refinancing can also involve a few additional considerations. Because a home equity loan is typically a separate lien on the property, refinancing your primary mortgage may mean you have to pay off the home equity loan or work with your lender to determine how the existing loan will be handled.

Making the Right Home Equity Choice

If you’re considering a home equity loan, your next step is to look at the numbers and explore the options available to you. Think about how much you need to borrow, what you can comfortably afford each month, and how the loan fits into your longer-term plans. 

And, luckily, you don’t have to figure it all out on your own!

A local lender at Amplify Credit Union can walk you through your options, answer any questions you have about your home’s equity, and help you decide on the loan that is best for your situation.

This article was originally published on June 2, 2021.