The Pros And Cons Of A Home Equity Loan (2024)

A home equity loan, often viewed as a financial lifeline, can provide homeowners with access to a substantial amount of funds by leveraging the value of their homes. But these loans also come with some risks. We’ll walk you through the pros and cons of a home equity loan to help you make an informed decision.

What Is a Home Equity Loan?

A home equity loan is a type of loan that allows homeowners to borrow money using the equity they have built up in their homes as collateral. Equity refers to the current value of your home minus any outstanding mortgage or liens. For example, if your home is currently valued at $400,000 and you owe $200,000 on your mortgage, you have $200,000 in equity.

Lenders typically issue home equity loans as a lump sum. Home equity loans also tend to have fixed interest rates, making it easier for borrowers to budget and plan for repayment.

Pros and Cons of a Home Equity Loan

A home equity loan may be a good idea for homeowners who need a large amount of money for a specific purpose, such as home renovations or paying off high-interest debt, but it’s essential to weigh the pros and cons before committing to this type of financing.

Pros

• Lower interest rates. Home equity loans generally offer lower interest rates than other loans or credit cards—usually around 8% to 10%. This can make them an attractive option for borrowers, especially those looking to consolidate higher-interest debt. Over time, the savings from a lower interest rate can be significant.
• Lump sum funding. Home equity loans provide a large amount of money upfront, which can be helpful to cover large expenses such as home renovations, college tuition or unexpected medical bills. This lump sum funding can provide financial relief or enable investments that significantly improve the quality of life.
• Potential tax deductions. With home equity loans, the interest paid on the loan might be tax-deductible for taxpayers who itemize deductions, potentially leading to substantial tax savings. However, you should consult a tax advisor to understand the tax implications.
• Improved credit score. A home equity loan can help improve your credit score if managed correctly. Consistent, on-time payments toward the loan can demonstrate to lenders that you are a reliable borrower, improving your creditworthiness.
• Flexibility. Home equity loans offer flexibility in how you use your funds. Unlike auto or student loans, which you must use for specific purposes, you can use the money from a home equity loan for various purposes.

Cons

• Foreclosure risk. While you can use home equity to build wealth, a home equity loan can also put your property at risk. Because the home secures the loan, defaulting on payments could lead to the lender seizing your home.
• Difficult qualification requirements. Like other loans, lenders impose several home equity loan requirements, such as your credit score, income, debt-to-income (DTI) ratio and loan-to-value ratio, before approving a home equity loan. Consider using a DTI ratio calculator to evaluate your risk to lenders.
• Costs and fees. Home equity loans often come with various costs and fees. These include application fees, appraisal fees, upfront charges, closing costs and early payment penalties. These costs can add up, potentially negating some of the benefits of the lower interest rate.
• Fluctuating home values. Your home’s value can fluctuate over time due to market changes. If the value of your home decreases, you could end up owing more than your home is worth, often referred to as being “underwater” on your loan.
• Debt consolidation risks. Using a home equity loan to consolidate higher-interest debt can seem appealing. Still, it effectively swaps unsecured debt for secured debt. You won’t lose your home if you default on a credit card payment—but if you default on a home equity loan, you could.

Differences Between HELOCs and Home Equity Loans

Home equity lines of credit (HELOCs) and home equity loans allow homeowners to borrow against the equity built up in their homes, but they function differently.

A home equity loan works similarly to a traditional loan, providing a lump sum of money upfront that is repaid over a fixed term, typically with a fixed interest rate. This kind of loan can be helpful for large, one-time expenses such as a significant home renovation or consolidating high-interest debts.

A HELOC, on the other hand, operates more like a credit card. Instead of providing a lump sum, a HELOC establishes a line of credit that can be drawn upon as needed, up to a specific limit. The interest rate on a HELOC is usually variable, meaning it can increase or decrease over time, typically in line with prevailing interest rates. A HELOC is more flexible than a home equity loan, allowing homeowners to borrow as needed.

However, with this flexibility comes the temptation to overspend, and the variable interest rate on a HELOC can lead to higher costs if rates increase significantly over time. Unlike home equity loans, HELOCs often come with an initial draw period, commonly up to 10 years, during which the homeowner can borrow money, followed by a period where the borrowed money must be repaid.

It’s important for homeowners to consider these factors and their own financial circ*mstances when deciding between a home equity loan and a HELOC.

5 Alternatives to a Home Equity Loan

If you don’t want to tap your home equity, there are several alternatives to consider—each with pros and cons.

1. Personal Loans

Personal loans can be a viable alternative to home equity loans. They are often unsecured, meaning your home isn’t used as collateral, reducing the risk of foreclosure. However, interest rates for personal loans can be higher than home equity loans, as lenders take on more risk. These loans are most beneficial for smaller expenses or debt consolidation and usually have fixed interest rates and a predetermined repayment schedule.

2. Credit Cards

Credit cards offer convenience and flexibility, especially for more minor, immediate expenses. Some credit cards offer 0% interest promotional periods, allowing you to make necessary purchases without immediate interest charges. However, your interest rate can increase significantly when the promotional period ends.

3. Refinancing

Refinancing could be a good option if mortgage rates are currently lower than when you took out your mortgage. Refinancing replaces your existing mortgage with a new one, potentially at a lower interest rate. Also, consider a cash-out refinance, which lets you borrow more than you owe on your current mortgage and use the difference to cover other financial needs. However, keep in mind that refinancing includes closing costs, home appraisal fees and other charges.

4. 401(k) Loan

Depending on your retirement plan, you may be able to borrow against your 401(k). This can be an attractive option as you’re essentially borrowing from yourself, and repayments go back into your account. However, you also lose out on potential investment growth during the loan term. And if you leave or lose your job, the loan often must be repaid in full, which can put you in a difficult financial position.

5. Life Insurance Loans

If you have a life insurance policy with a cash value component, you may be able to borrow from it. This type of loan doesn’t usually require a credit check, and interest rates are typically low (between 5% and 8%). However, if not repaid, the outstanding loan balance will be deducted from the death benefit when the insured person dies, reducing the amount beneficiaries receive.

Do Home Equity Loans Have Fees?

Home equity loans typically come with various fees that can increase the loan’s overall cost. That said, the best home equity loan lenders offer competitive fees to keep borrowing costs low. Factor these additional costs into the decision-making process:

• Origination fee. Lenders charge origination fees as part of your closing costs to cover the costs of processing the new loan. Home equity loan origination fees typically range from 0.5% to 1% of the loan amount.
• Appraisal fee. An appraisal fee is the cost of ordering a home appraisal. Lenders use your home’s appraised value to determine how much you can borrow. This typically costs around $300 to $450.
• Early payoff fee. Some lenders charge a prepayment penalty if you repay the loan before its term ends. This may be a flat fee or a percentage of the total loan.
• Late payment fee. A late payment fee applies if you make a payment after its due date.
• Other closing costs. Additional costs of finalizing the loan may include attorney fees, a title search fee and a document preparation fee.