Homeowners who’ve purchased in the last year or two might be looking at their situation right now and feeling pretty lucky: They bought before interest rates skyrocketed, and some are sitting on significant home equity.
If you’re in that camp, or if you bought before this housing boom, and you’re looking to take advantage of that equity, a home equity loan could be a great option. It’s a way to borrow a lump sum of money — to fund a home renovation or a debt consolidation, for example — with a relatively low interest rate compared to other forms of debt. And unlike in a cash-out refinance, which was a popular option until recently, you won’t have to give up a low interest rate on your primary mortgage.
But before you go for a home equity loan, you should consider the potential drawbacks, too. Here’s what you need to know about the pros and cons.
What Is a Home Equity Loan?
A home equity loan is a second mortgage, which means it’s a loan against your house that takes a “second position” after your primary mortgage. You can use the money for anything, and would receive the cash in a lump sum once the loan is approved.
“You are essentially taking the equity, or what you have in your home, and borrowing against it,” says Marguerita Cheng, a certified financial planner at Blue Ocean Global Wealth.
This is different from a home equity line of credit, which also draws on your home equity but functions more like a credit card, where you only pay back what you spend. Home equity loans, by contrast, are more rigid: You take out a set chunk of cash all at once, and pay it back in fixed payments (with interest) over the life of the loan — usually 20 or 30 years.
Pros of Home Equity Loans
There are a lot of reasons borrowers like home equity loans: They’re one of the cheapest forms of debt available, they can give you a large sum of money upfront and their payments are predictable.
“Many people have untapped equity in a home,” says Charles Sachs, certified financial planner at Kaufman Rossin Wealth, LLC in Miami. A home equity loan is a great way to tap into it; these are the main benefits:
Relatively lower interest rates
Interest rates for just about every type of debt are going up right now. But generally speaking, loans that are secured by your home offer some of the lowest interest rates — especially compared to credit cards or personal loans.
Right now, interest rates for a home equity loan are as low as 5%, compared to 10% or sometimes even 20% on credit cards. Plus, when you take out a home equity loan, you’re locking in the rate, meaning it will stay the same for the life of the loan.
You can think of payments on a home equity loan much the same way you do your primary mortgage: The payment that’s set at the very beginning is the payment you’ll pay every month, for decades.
“With a home equity loan [the benefit] is that it is a fixed payment,” Cheng says. “Not only is the interest rate fixed, but your payment is fixed.”
That predictable amount makes it easier for you to budget, and to make sure you’ll be able to afford the payments for the entire life of the loan.
Potential tax benefits
“That’s a huge benefit, especially if you’re taking the money in your home and putting it back in your home,” Cheng says. She recommends talking with a tax professional to understand what the tax implications are in your specific case. But there’s potential that it could lower your tax bill at the end of the year.
Cons of Home Equity Loans
Just like any form of debt, home equity loans have some drawbacks, too. Receiving a lump sum of cash all at once can be dangerous for the undisciplined, and the interest rates — while low compared to other forms of debt — are higher than primary mortgages.
Potential for overspending
You might need a lump sum of money for a large project, but receiving tens of thousands of dollars at once can be tempting. Cheng cautions that if you’re not disciplined about using the money for a specific purpose, you could get into trouble.
Experts recommend that you don’t use the funds for daily living expenses, or luxuries like a boat or fancy car — especially because if you default on the loan, your home is at risk.
More expensive than a primary mortgage
The simple fact of home equity loans is that they come second to your primary mortgage. That means if you stop making payments, the home equity lender is in line behind your primary mortgage. To compensate for that, interest rates are slightly higher on home equity loans than they are on your original mortgage.
Longer, costlier application process
Taking out a home equity loan isn’t as quick or easy as applying for a new credit card. The process usually takes weeks, or sometimes months, as the bank looks over your application and credit history.
These loans might also involve fees or closing costs, meaning there’s a cost to accessing your home equity. Check with a lender to understand what fees you might be liable for.
Lower interest rates than other forms of debt
Payments are the same for the life of the loan
Interest could be tax deductible if used for home improvements
You could overspend if you take out too much
Interest rates are higher than for a mortgage
Application process is longer and more expensive than for credit cards
Alternatives to Home Equity Loans
Maybe a home equity loan isn’t right for you. Consider some of the other options for tapping home equity and accessing funds:
Home equity lines of credit are another popular option, and for good reason. They offer a level of flexibility that a home equity loan doesn’t. HELOCs work like a credit card: You can spend up to a certain limit during the draw period, and you pay back only the amount you spent. But be aware that HELOCs often have variable interest rates, and those are only likely to go up in the near future; that makes your payment very unpredictable.
A cash-out refinance is a way to recast your primary mortgage to a higher amount, and extract the difference — some of your home equity — in cash. This is another way to access a lump sum of funding. But it would also mean forfeiting your current mortgage interest rate, which is likely a lot lower than current rates.
That said, it’s important to crunch the numbers. Cheng advises that you compare the “blended” rate of your primary mortgage and a home equity loan, and compare that to the single interest rate on a cash-out refinance. “If you’re borrowing a lot of money, you may want to do a cash-out refinance,” Cheng says.
When deciding between a home equity loan and a cash-out refinance, compare the combined rate of interest you’d pay with both your current mortgage and the home equity loan with what you’d get with a cash-out refi.
Unlike home equity lending, a personal loan is typically not secured by your house. That means it’s riskier for banks (because they have nothing to fall back on), and the interest rates are much higher as a result.
“It’s definitely a question of, what do you need, how much do you need, and what is the purpose?” Cheng says.
There is, of course, one other way to fund your project: Cold hard cash.
In the environment of rising interest rates, it could be a good idea to forgo debt entirely, and simply save up the money for that home renovation. Cheng suggests making a monthly contribution to your savings, and earmarking a portion of any unexpected windfalls toward that goal.
It’s also not a bad idea to save about 25% more than you think you’re going to need. “No one has ever fired me for having them set aside too much,” Cheng says.