How Home Equity Loans Work: Pros and Cons
Borrow Against Equity in Your Home
Home equity loans allow you to borrow against your home’s value. They provide access to large amounts of money, and they can be easier to qualify for than other types of loans because they are secured by your house.
If your home is worth more than you owe on it, a home equity loan can offer funds for anything you want—you don’t just have to use the money for home-related expenses. However, using your home to guarantee a loan comes with risks.
A home equity loan is a type of second mortgage. Your “first” mortgage is the one you used to purchase your home, but you can use additional loans to borrow against the property if you have built up enough equity.
Benefits of Home Equity Loans
Home equity loans are attractive to both borrowers and lenders. Here are a few of the key benefits for borrowers:
- Low rates: Home equity loans typically have a lower interest rate (usually quoted as APR) than unsecured loans such as credit cards and personal loans. A low rate can help keep borrowing costs low, but closing costs may offset low rates.
- Approval: Home equity loans may be easier to qualify for if you have bad credit. With your home securing the loan, lenders have a way to manage their risk. That said, mortgage loans often require extensive documentation, and lenders set minimum requirements that may make it hard to borrow—even if you have significant equity.
- Large amounts: Borrowers can qualify for relatively large loans with this type of loan, assuming you have sufficient equity in the home. For large expenses like home improvements, higher education, or starting a business, your home equity may be the only source of funding available.
- Potential tax benefits: You may be able to deduct some of the interest you pay on a home equity loan, particularly if you use the funds for "substantial improvements" to a property. Ask your tax preparer for details before you borrow and before you claim a deduction.
Safety for lenders: Most the benefits above are available because home equity loans are relatively safe loans for banks to make: The loan is "secured" with your house as collateral.
If you fail to repay, the bank can take your property, sell it, and recover any unpaid funds by foreclosing on your home. What's more, borrowers tend to prioritize these loans over other loans because they don’t want to lose their homes. When faced with the choice of missing a mortgage payment or a credit card payment, you might decide to skip the card payment.
Approval is not guaranteed: Collateral helps, but lenders have to be careful not to lend too much, or they risk significant losses. Before 2007, it was extremely easy to get approved for first and second mortgages. Since the housing crisis, things have changed, and lenders will carefully evaluate your application. To protect themselves, they try to make sure that you don’t borrow any more than 80 percent or so of your home’s value—taking into account your original purchase mortgage as well as any home equity loan you’re applying for.
The percentage of your home's value available is called the loan to value (LTV) ratio, and may vary from bank to bank—some lenders allow LTV ratios above 80 percent.
Home equity loans are only approved if you can demonstrate that you have the ability to repay. Lenders are required to verify your finances, and you'll need to provide proof of income, access to tax records, and more.
How a Home Equity Loan Works
When you borrow with a home equity loan, you can use one of two options:
- Lump-sum: Take a large sum of cash up front, and repay the loan over time with fixed monthly payments. Your interest rate can be set when you borrow and remain fixed for the life of your loan. Each monthly payment reduces your loan balance and covers some of your interest costs (it is an amortizing loan).
- Line of credit: Get approved for a maximum amount available, and only borrow what you need. Known as a home equity line of credit (HELOC), this option allows you to borrow multiple times after you get approved. In the early years, you can make smaller payments, but at some point, you have to start making fully amortizing payments that eliminate the loan.
The HELOC is the most flexible option because you always have control over your loan balance—and your interest costs. You only pay interest only on the amount that you actually use from your pool of available money. However, your lender can freeze or cancel your line of credit before you have a chance to use the money. Freezes can happen when you need the money most and unexpectedly, so that flexibility comes with some risk.
Interest rates on HELOCs are typically variable, so your interest charges can change (for better or worse) over time.
To get a loan, apply with several lenders and compare all of the lender costs along with interest rate quotes. Get a Loan Estimate from several different sources, including a local loan originator, an online or national broker, and your preferred bank or credit union. Interest rates may vary from place to place, and you’ll have to pay closing costs to get your loan funded. Lenders will check your credit, require an appraisal, and it may take several weeks (or more) to release any money. Treat the process as if you were applying for a home purchase loan: Get your pay stubs and other documents organized to make the process go faster.
Repayment depends on the type of loan you get. With a lump-sum loan, you typically make fixed monthly payments (you pay the same amount every month) until the loan is paid off. With a line of credit, you may be able to make small payments for several years during your “draw period,” which might last ten years or so. After the draw period ends, you’ll need to start making regular amortizing payments to pay off the debt. However, you can typically pay off either type of loan early to save on interest charges.
Common Home Equity Loan Uses
You can use a home equity loan for anything you want. However, borrowers usually use second mortgages for some of life’s larger expenses because homes tend to have a lot of value to borrow against. Several popular uses include:
Pitfalls of Home Equity Loans
Before using a home equity loan for any purpose, be sure to understand the risks of using these loans. The main problem is that you can lose your home if you fail to stick to the monthly payment schedule that your lender requires.
Significant debts: Because these loans can provide a lot of cash, it's tempting to use your home as an ATM. But it’s best to reserve your home's equity for things that will improve the value of your home, add significant value to your life (this does not include “wants” or luxuries), or lead to a higher income for your family. This is a case where it’s particularly important to evaluate loans as “good” debt and “bad” debt.
Fees: Closing costs are also an issue. Borrowing against your home can cost thousands of dollars—and that’s before you even spend any of the money on home repairs or tuition. If you frequently borrow against your home, it’s an expensive habit (although using lines of credit can help you manage the costs).
How to Find the Best Home Equity Loans
Finding the best home equity loan can save you thousands of dollars or more. To get the best deal:
- Shop around. Different lenders have different loan programs available, and their fee structures can vary dramatically.
- Manage your credit scores and make sure your credit reports are accurate. If there are any errors or easy-to-fix issues in your credit reports, use rapid rescoring to get quick improvements that can lead to better rates.
- Ask your network of friends and family who they recommend. Ask local real estate agents which loan originators do the best job for their clients.
- Compare your offers to those found on websites and advertisements. Remember that the best rates are only available for borrowers with high credit scores and plenty of income to cover payments. Read your Loan Estimate carefully to see if you’re paying the same amount you expected.
Is it the right loan? Before you borrow, pause and make sure that this type of loan makes sense. Is a home equity loan a better fit for your needs than a simple credit card account or an unsecured loan? If you’re not sure, figure it out before you put your home at risk. Those loans may have higher interest rates, but you may come out ahead by avoiding closing costs.
Make a plan: Make a detailed plan of your income and expenses—including this new loan payment—before you close the loan. These large loans can come with hefty payments. Plus, the payments may increase over time if you have a variable rate. If there's any way to do what you want to do without taking on debt, give those options serious consideration.
Protect yourself and your family: Review your insurance coverage (life and disability in particular) and evaluate how you’ll cover the payments if something happens. You may or may not need insurance, and nobody can force you to use it. If you decide to include coverage as part of a home equity loan, go with monthly premium payments—not an up-front option—so that you only pay for what you use (assuming the insurance is just for the home equity loan). As with any other financial product, get quotes from a variety of sources, including online and independent insurance agents.
You don’t have to buy insurance that your lender offers.
Retirement income: If you’re planning to tap your home equity for living expenses in retirement, evaluate reverse mortgages, which may be easier for seniors to qualify for. However, familiarize yourself with the risks and rule out the alternatives before you take that step.
Interest deduction (Pre-2018): For tax years up to and including 2017, it was possible for some taxpayers to deduct interest paid on home equity loans. For tax-year 2018 and after, as a result of the Tax Cuts and Jobs Act, that deduction is no longer available (although limited deductions on home purchase loans may be available). Speak with a CPA to find out how your home loans may affect your taxes.