Understanding the pros and cons of a home equity loan

If you need to borrow a large sum of money, a home equity loan seems like a logical choice. The payments can be a lot more manageable than using something like a personal loan, after all. Besides, it’s your home equity that you worked hard to acquire — why not use it to your advantage?

Home equity loans can indeed work well in many cases, but they’re not always the best tool for the job. In order to make an educated decision, you need to know the pros and cons of home equity loans, along with your other borrowing options. Taking this approach can help you gain more confidence that you’re making the right choice, whether that includes a home equity loan or not. 

How home equity loans work

A home equity loan allows you to borrow a lump sum of cash against the equity you’ve built up in your home. You’ll then repay this amount with a fixed interest rate over the course of several years. 

Lenders will file a lien on your home, similar to your mortgage lender (if you’re still paying off your home). In fact, that’s how home equity loans get their other name: second mortgages. When you repay the full amount of the loan, the lender will remove the lien.

Using your home as collateral for the loan means a few things. Most importantly, if you default on the debt, your home equity loan lender can foreclose on your home. That rarely happens to homeowners, but because lenders have more assurance they’ll recoup their costs, they’re often able to pass on lower interest rates to all borrowers compared to unsecured debts like personal loans. 

The pros and cons of home equity loans

Here are the key things you should know about taking out a home equity loan:

Pros of home equity loans

• Flexible funds: Homeowners can use a home equity loan for nearly anything. Popular reasons for taking one out include home repairs and renovation projects, consolidating debt from a higher interest rate, and putting a down payment on a new property.  
• Long-term length: You can choose to pay off a home equity loan over a longer period of time, often from five to 30 years. A longer payback period translates into a smaller monthly payment, which can be easier to manage in your budget.  
• Low interest rates: Rates are also typically lower for home equity loans than unsecured debts like personal loans. This, too, can help lower your monthly payment and save you extra money in the long run. 
• High payout potential: You can generally borrow up to 80% of the equity in your home. That can be a substantial loan amount, even if you still have a mortgage you’re working to pay back.
• Predictable payments: The fixed interest rates that lenders charge mean your monthly home equity loan payment will stay the same until you pay it off. That can add predictability to your budget, so you don’t need to worry if rates rise in the future. 
• Possible tax deductions: If you use your home equity loan to fund home renovations, you may be able to deduct some of the interest you pay on your financing. 

Cons of home equity loans

• One-time payout: A home equity loan only provides funds after you’re first approved for the loan. If you have ongoing borrowing needs, a home equity line of credit (HELOC) may be more suitable. 
• Lower home equity: Taking out a loan against your home’s value means that you’ll have less equity. If home values decline, you could end up owing more than your home is worth. It can also make it more difficult to sell your home. 
• Closing costs and fees: You’ll go through a similar underwriting process to a mortgage when you take out a home equity loan. That includes appraisal fees and other charges, too. Most homeowners end up paying between 2% and 5% in closing costs. 
• Long closing timeline: The underwriting process for a home equity loan can also take a few weeks. You may need to get a home appraisal, and your lender may perform a title search, check your credit report, prepare legal documents, etc.  
• Credit and equity requirements: You’ll still need to meet the qualifications to get a home equity loan, which vary depending on the lender. Notably, for most lenders, that involves having a credit score of 620 or higher and having at least 15% to 20% equity in your home. 
• Foreclosure risks: If you don’t repay the loan, your lender can foreclose on your home. They’ll then sell your home to repay your debt (including your mortgage lender, if applicable) and distribute any remaining funds to you. This is rare, but it can happen.

When a home equity loan makes sense

Any homeowner with sufficient equity, credit, and income can potentially qualify for a home equity loan. Financial experts tend to recommend home equity loans more often in particular cases, though. Let’s take a look at when a home equity loan might make more sense for you:

• You’re on solid financial footing: It’s not great to default on any loan, but especially one that could result in you losing your home. A sufficient and stable income, coupled with strong budgeting skills and a well-stocked emergency fund, can help you limit this risk. 
• You’re consolidating high-interest debt: Since you’re using a major asset to borrow money, it’s best to use a home equity loan for things that grow your wealth, too. Paying off high-interest credit card debt can help you do that by saving money and getting rid of that liability faster, but — importantly — only if you stay out of credit card debt, too. 
• You don’t have any upcoming plans to move: If you need to move, your home equity loan will be paid off with the sale proceeds, along with your mortgage (if you have one). That leaves less money for you to fund your move and buy a new home. Additionally, if home prices fall, it’s possible to owe more than you can sell the home for. 
• You’re using the funds for home improvements: It’s best to verify with an accountant first, but in some cases, you may be able to write off your home equity loan interest on your taxes. To count, though, you’ll need to spend the funds on “substantial improvements” to your home.

Alternatives to home equity loans

Owning your own home means that you have more avenues available when you need financing. A home equity loan is not the only way that you can leverage your home to access credit when you need it. Here are four other options that are worth exploring:

• HEI: A home equity investment isn’t a traditional loan, but a partnership. You share a slice of your home’s future equity growth and get a lump sum of funds in return. In 30 years, you’ll repay the amount you borrowed, plus a share of the home’s appreciation through a home, sale, refinance, or another source of funds. You don’t need to make any payments in the interim period. Qualifications are less stringent — there are no income requirements, and homeowners can qualify with a credit score above 500.
• HELOC: A home equity line of credit is another type of second mortgage. It offers access to a line of credit for a multi-year draw period, where you’ll only pay interest. You’ll then pay back principal-plus-interest during the repayment period. Monthly HELOC payments could thus change a lot, especially because they charge variable interest rates. 
• Reverse mortgage: A reverse mortgage allows you to borrow against your home’s equity and repay it from the sale of your home when you no longer need it. Not everyone qualifies for a reverse mortgage; only those age 62 or over can use them. A major benefit of reverse mortgages is that you don’t need to make monthly payments. 
• Cash-out refinance: If you still have a mortgage balance, a cash-out refi replaces your current mortgage with a larger one. The difference is paid back to you in a lump sum. You then only have one loan to repay, which combines your old debt with your new one.

Frequently asked questions

What is the downside to getting a home equity loan?

The risk of foreclosure is the biggest downside to getting a home equity loan. If you don’t make your payments, you could lose your home. A home equity loan also reduces your home equity, which can make it tougher to sell the property, especially if home values decline in the future. 

What is the catch to a home equity loan?

There is no “catch” to getting a home equity loan, but some people aren’t as aware that they risk losing their home if they’re unable to make their payments. Taking out a home equity loan could have other unintended consequences, too, like ending up in an upside-down loan if your home’s value goes down. It could also add additional snags if you need to sell your home before the loan is repaid, since you won’t get as much money back from the sale after paying off the debt.

How much would a $50,000 home equity loan cost per month?

A 30-year, $50,000 home equity loan would cost $439 per month, assuming that you don’t roll any of the closing costs into the loan and that you’re paying an interest rate of 10% APR. You can use a home equity loan calculator to see the exact cost for any financing options you’re interested in using. 

What is not a good use of a home equity loan?

Home equity loans generally aren’t a good choice if you need to borrow and repay smaller amounts of money on a more frequent basis, like for ongoing projects. If you need to borrow money to cover these expenses, it’s better to choose something like a home equity line of credit (HELOC), which allows flexible borrowing. 

Final thoughts

Now that you understand the implications of taking out a home equity loan, you’re in a better position to make a good decision. In general, home equity loans can be a good choice if you need a lump sum and an affordable payment, especially if your income is secure and you don’t have any plans to move for a while. They’re especially good choices for things like debt consolidation or enhancing your home’s value with upgrades and improvements. 

If a home equity loan isn’t right for you, though, you still have many options available as a homeowner. It’s a good idea to consider consulting a financial advisor who can help you make the right call if you’re not sure which is best. 

Ready to tap into your home equity with no monthly payments? Explore Point’s Home Equity Investment to learn more.