What is a Home Equity Loan?A home equity loan is precisely what it sounds like–a loan that a homeowner takes out, using their home equity as collateral. Home equity loans are often referred to as “second mortgages.”
Unlike personal loans, for example, a home equity loan is a secured loan. It is secured by your home equity, which means that it may have lower interest rates, but also that if you fail to make payments, you could lose your home to foreclosure.
When you take out a home equity loan, you will typically receive a single lump sum payment, which you will pay back over a fixed term (anywhere from 5-30 years), with a fixed interest rate attached. These factors are in contrast to a home equity line of credit (HELOC), with which you borrow flexibly over a draw period, and which frequently has a variable interest rate that can change with market conditions.
Homeowners use home equity loans to pay for anything from home renovations to debt consolidation–there are no required uses.
Pros of Home Equity Loans
Fixed Interest Rate:Unlike HELOCs, home equity loans have a fixed interest rate. Throughout the term of the loan, the interest rate will remain the same, which makes it easier for the homeowner to budget and plan accordingly.
Predictable Monthly Payments:If you thrive most with highly structured arrangements, home equity loans come with a fixed repayment term. This means that, combined with the fixed interest rate, homeowners will know exactly how much each monthly payment will be, and when the loan will be paid off.
Extended Repayment Periods:A longer repayment period usually results in smaller monthly payments. When you set the terms with your lender, it’s possible to request an extended repayment period–up to 30 years.
Flexible Uses:While some loans that may have restrictions on how the funds can be used, home equity loan funds can be used for a variety of purposes, providing flexibility to homeowners.
Tax Advantages:In some cases, the interest paid on a home equity loan may be tax-deductible, particularly if the funds are used for home improvements. Check recent tax laws, nationally and at the state level, to see what tax benefits are available to you.
Cons of Home Equity Loans
Risk of Foreclosure:Never forget that a home equity loan is secured by your home! This means that if you cease to make payments, you risk losing your home by foreclosure.
Higher Lending Criteria:Like other types of loans, home equity loans often have specific lending criteria that borrowers must meet in order to qualify. The criteria for a home equity loan can vary among lenders, but generally, these loans may have somewhat higher lending standards compared to certain other types of consumer loans.
Higher Interest Rates:In general, home equity loans often come with higher interest rates compared to primary mortgages or other types of secured loans. One reason for this is that home equity loans are often in the second lien position, meaning they are subordinate to the primary mortgage. Therefore, in the event of foreclosure, the primary mortgage lender gets paid first from the sale proceeds, and the home equity lender receives any remaining funds. This additional risk could be reflected in the interest rate.
Upfront Fees & Closing Costs:Home equity loans are often accompanied by upfront costs, including application fees, appraisal fees, closing costs, and other charges.
Risk of Overspending:If you don’t have a set plan for how you want to use the funds, you may spend the money frivolously and end up with debt that outlasts the benefits of the purchases.
Added Debt:Taking on a home equity loan adds to your overall debt burden. Unless you are using the loan to consolidate other high-interest debt, piling on an extra debt may not be a wise choice.
Should I Get a Home Equity Loan?You’re the only one who can ultimately decide whether a home equity loan is a good choice for you and your finances. If you’re weighing your options, though, here are a few factors to consider.
A home equity loan might be a good idea for you if:
- You intend to make home improvements or repairs which can potentially increase the value of your home. Upgrades such as adding a room or remodeling a kitchen can be especially fruitful–and you may be able to deduct the interest on your taxes.
- You have high-interest debt that you want to consolidate, such as credit card balances. Home equity loans can have lower interest rates compared to credit cards or other unsecured loans, so you could save money in the long run.
- You have a specific expense with a well-defined cost, such as a major medical procedure or other one-time cost, a home equity loan with a fixed interest rate and predictable monthly payments can provide stability for budgeting.
However, a home equity loan may be a bad idea for you if:
- You're in a precarious financial situation with unstable income, high levels of existing debt, or a poor credit history. Taking on additional debt with a home equity loan can only make your situation more dire–and you risk losing your house as well.
- You want to fund non-essential or luxury expenses, such as vacations, entertainment, or other discretionary purchases that don’t provide long-term value.
- You seek to invest in speculative ventures, such as the stock market or high-risk business ventures. If the investments don’t perform well, you could be putting your home at risk.
- The real estate market is experiencing a downturn and property values are declining. In that case, taking out a home equity loan may result in owing more than your home is worth.
Alternatives to Home Equity LoansIf you want to tap into your equity, but aren’t quite sure whether a home equity loan is the right method, consider comparing it to some of the other solutions available:
Home Equity Loan vs. HELOC
A home equity loan provides a lump sum of money upfront, which is typically repaid in fixed monthly installments over a set period. The HELOC, meanwhile, allows you to withdraw what you need, during which time you simply pay interest on that amount. It is only subsequently during the repayment period that you repay the loan itself in addition. HELOC interest rates also tend to be variable, rather than fixed, which is another key difference between the two products.
Home Equity Loan vs. Cash-Out Refinance
In a cash-out refinance, the homeowner replaces their existing mortgage with a new, larger one. The new mortgage pays off the old one and provides a cash payout for the difference between the two loans. In contrast, a home equity loan is a separate loan in addition to your existing mortgage.
Home Equity Loan vs. Reverse Mortgage
A reverse mortgage enables homeowners who are age 62 or older to convert a portion of their home equity into cash without selling the home. The loan is repaid (with interest) when the homeowner sells the home, moves out of the home, or passes away; there are therefore, unlike with a home equity loan, no monthly payments.
Home Equity Loan vs. Equity Sharing Agreement
An equity sharing agreement, such as one with Unison, gives the homeowner a portion of their home’s current value in cash. In exchange, instead of the monthly payments and interest charges that home equity and other loans offer, the homeowner will pay them the original amount plus an agreed-upon percentage of the home’s change in value at the end of the agreement (usually the time of sale).
Unison’s equity sharing agreement empowers homeowners to tap into their equity without needing to add to their retinue of monthly payments, or worry about interest rates. If that sounds promising, you can get a free estimate from Unison’s website with absolutely no obligation, or effect on your credit.