FG Trade/GettyImages; Illustration by Hunter Newton/Bankrate
Key takeaways
- The benefits of a home equity loan include consistent monthly payments, lower interest rates, long repayment timelines and a possible tax deduction.
- The downsides of a home equity loan include a significant equity requirement and the potential to lose your house or owe more than your home is worth.
- If a home equity loan isn’t right for your needs, consider a home equity line of credit (HELOC), cash-out refinance, personal loan or reverse mortgage.
When you’re in need of credit or a loan, you can choose between two main types: secured loans, which require collateral to back (secure) the debt; and unsecured loans, which don’t. Home equity loans fall into the former category, with your home serving as the collateral.
That’s a lot to lay on the line. Are home equity loans a good idea? Here are the pros and cons to consider.
What is a home equity loan?
A home equity loan is a type of second mortgage that allows you to obtain a fixed amount of money by leveraging some of the equity in your home — that is, the difference between your home’s value and what you still owe on your mortgage.
A home equity loan comes with a fixed interest rate and gets repaid just like a mortgage: monthly payments over a set period, usually 30 years. This loan can be used for any purpose, such as covering educational costs, renovating your home or managing medical expenses.
Pros and cons of a home equity loan
Pros of a home equity loan
- Predictable interest rate: A home equity loan has a fixed interest rate throughout the entire loan term, which means that, regardless of fluctuations in the market, your interest rate won’t change. You’ll know exactly how much you’re paying to take out the loan and don’t have to sweat out skyrocketing rates.
- Consistent monthly payments: Since the interest rate remains fixed, your monthly mortgage payment will also remain consistent over the life of the loan. This consistency can make it much easier to plan and budget your monthly expenses.
- Relatively lower interest rates: Home equity loans typically offer lower interest rates compared to personal loans or credit cards. “While you may pay closing costs or other fees, it’s an inexpensive alternative to an unsecured loan,” says Laura Sterling, vice president, Marketing at Georgia’s Own Credit Union in Alpharetta, GA. Being backed (secured) by your property reduces the loan’s risk for banks and mortgage companies, and so they charge less for it.
- Extended repayment periods: Home equity loans come with long repayment timelines spanning up to 30 years. This extended period, combined with a relatively lower interest rate, could translate to more manageable monthly payments.
- Larger borrowing potential: Depending on the size of your equity (ownership) stake, a home equity loan might allow you to obtain larger sums than you could with a credit card or personal loans. We’re talking five and six figures here.
- Tax advantages: If you use the funds from the loan to make significant home improvements or repairs, the interest you pay on the home equity loan is tax-deductible (assuming you itemize deductions on your return). This can provide you with additional savings and potentially reduce your overall tax burden. “Because there are limitations on what you can deduct, it’s always best to consult your tax advisor,” says Sterling.
Cons of a home equity loan
- Chance of losing your house: Simply put, if you don’t repay the loan, your lender could foreclose. Aside from displacing you or other occupants, a foreclosure does long-lasting harm to your credit, making it more difficult for you to get a mortgage or other types of financing for some time.
- Minimum equity requirement: You typically can’t take out a home equity loan unless you have at least 20 percent equity (although some lenders allow for 15 percent) — that is, own one-fifth of your home outright. If you’re a new homeowner and didn’t put a lot of money down, that means you’ll need to wait a while before you can leverage your equity at all.
- Closing costs: Home equity loans come with charges such as origination and appraisal fees.
- Longer funding time: The process isn’t quite as onerous as that of a traditional mortgage, but applying for and receiving the funds with a home equity loan takes longer than the process of getting a personal loan. In short: A home equity loan isn’t a great option if you need cash fast.
- Heftier monthly payments: A home equity loan means one more expense on top of your mortgage.
- Risk of negative equity: If there is a significant drop in the local residential real estate market or the desirability of your neighborhood, the value of your home might decline, leaving you “underwater” with a loan balance that exceeds the property’s worth. “If your home value declines, you could owe more on your home than it is worth, making it hard to sell,” Sterling says.
Do all home equity loans have fees associated with them?
Most lenders charge fees for a home equity loan. Count on possibly paying for the following:
- Origination fee: The amount varies depending on the lender and how much you’re borrowing.
- Appraisal fee: This usually costs anywhere from $300 to $800.
- Credit report fee: The lender will charge you a nominal fee to pull your credit report, as little as $10 or up to $100 per credit report.
- Document or filing fees: According to the Homebuying Institute, the average county recording fee at closing is $125.
- Title fees: Since the home serves as collateral for a home equity loan, lenders conduct a title search to determine if there are any existing liens or claims on the property. This fee can fall within the range of $75 to $200, depending on location; some go as high as $450.
- Discount points: Some lenders allow you to pay upfront fees, known as “points,” to lower your interest rate. Each point costs 1 percent of the borrowed amount.
Home equity loans vs. HELOCs: What’s the difference?
Both home equity loans and HELOCs (short for home equity line of credit) let you borrow against your home equity, with your property serving as collateral for the debt. With either option, you can use the funds however you’d like – whether that’s for home renovation, college expenses or debt consolidation.
While these financial tools serve a similar purpose, they work differently. For one, home equity loans have fixed interest rates, while the rates on HELOCs are typically variable.
When you take out a home equity loan, you’ll receive the funds in a lump sum. On the other hand, HELOCs are revolving lines of credit (like credit cards), letting you withdraw money as you need it.
With a home equity loan, your monthly repayment amount will remain the same for the life of your loan (usually 10 to 30 years). In contrast, HELOCs have an initial 5- to 10-year draw period, when you can take out money as needed – and, optionally, only pay back the interest. After that, you’ll enter the repayment period, which generally lasts between 10 and 20 years. During this time, you’ll have to pay back the amount you borrowed, plus interest.
Other alternatives to home equity loans
If you’re not sure whether a home equity loan is the best choice, explore these other options:
- Cash-out refinance: Instead of taking out a second mortgage, a cash-out refinance involves replacing your existing mortgage with a new loan for a larger amount, the difference of which you’ll receive in cash to use for any purpose. The main upside: You’ll have one monthly payment instead of two. The downside: If you currently have a low mortgage rate, it might not make sense to get a new loan at today’s higher rates.
- Personal loan: Personal loans don’t require collateral, so your home and any other assets are safe. However, you can’t borrow as much with a personal loan (typically less than $100,000), and you’ll almost certainly pay a higher interest rate compared to a home equity loan.
- Reverse mortgage: For those who are 62 and older (or 55 and older with some products), a reverse mortgage offers another way to tap home equity. Unlike a HELOC or a home equity loan, the money withdrawn using a reverse mortgage doesn’t have to be repaid in monthly installments. Instead, the lender pays you each month while you continue to live in the home. The loan, plus interest, must be repaid when the borrower dies, permanently vacates or sells the home.
FAQ: home equity loan pros and cons
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Before you tap your ownership stake, compare a home equity loan to a HELOC. With a home equity loan, you receive a lump sum upfront, making it suitable when you have a specific expense or amount in mind. It also provides the advantage of a fixed interest rate for the entire loan term.
In contrast, HELOCs work similarly to credit cards, offering a revolving line of credit. You have the flexibility to borrow (and pay interest on) only what you need, when you need it. HELOCs are suitable if your total costs aren’t well-defined or you have substantial expenses that will span an extended time frame.
However, one of the most significant downsides of a HELOC is that they come with a variable interest rate, meaning that your monthly payments can increase.
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Yes. You can take equity out of your home even if you own it free and clear. In fact, it might be easier to get a home equity loan if you’re mortgage-free: Because your residence doesn’t have any other debts attached to it, you can access a much larger amount of your ownership stake. Plus, without a monthly mortgage payment, you could qualify for a bigger and less-expensive loan.
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A cash-out refinance pays off your existing mortgage and replaces it with a new one – and that includes a new interest rate and repayment term. Going that route might make sense if rates have dropped since you took out your original loan and you plan to stay in your home long-term. However, if you’re happy with your current rate, have a strong credit score and need cash for a specific purpose, then a home equity loan might be a better fit.
Additional reporting by Taylor Freitas
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