How Home Equity Loans Work: Pros and Cons
Borrow against the equity in your home—but be careful
Home equity loans allow you to borrow against your home’s value over the amount of any mortgages against the property. They can provide access to large amounts of money, and they can be a little easier to qualify for than other types of loans because they're secured by your home.
A home equity loan is a type of second mortgage. Your “first” mortgage is the one you used to purchase the property, but you can use additional loans to borrow against it if you've built up enough equity. Using your home to guarantee a loan comes with some risks, however.
How a Home Equity Loan Works
You can use one of two options when you borrow with a home equity loan.
You can take a large lump sum of cash up front and repay the loan over time with fixed monthly payments. Your interest rate will be set when you borrow and should remain fixed for the life of your loan. Each monthly payment reduces your loan balance and covers some of your interest costs. This is an amortizing loan.
Get might also get approved for a home equity line of credit (HELOC) for a maximum amount available and only borrow what you need from that amount. This option allows you to borrow multiple times after you get approved. You can make smaller payments in the early years, but at some point, you must start making fully amortizing payments that will eliminate the loan.
The HELOC is the most flexible option because you always have control over your loan balance—and, by extension, your interest costs. You pay interest only on the amount that you actually use from your pool of available money.
Your lender can freeze or cancel your line of credit before you have a chance to use the money, however. Freezes can happen when you need the money most and they can be unexpected, so the flexibility comes with some risk.
Interest rates on HELOCs are typically variable. Your interest charges can change for better or worse over time.
Repayment depends on the type of loan you get. You'll typically make fixed monthly payments on a lump sum loan, paying the same amount every month until the loan is paid off. You might be able to make small payments for several years during your “draw period" with a line of credit. Draw periods might last 10 years or so. You’ll need to start making regular amortizing payments to pay off the debt after the draw period ends.
You can typically pay off either type of loan early to save on interest charges.
The Benefits of Home Equity Loans
Home equity loans are attractive to both borrowers and lenders. They can offer funds for anything you want if your home is worth more than you owe on it. You don’t necessarily have to use the money for home-related expenses, and these loans typically have lower interest rates than credit cards and personal loans, usually quoted as APR. A low rate can help keep borrowing costs low, but closing costs can sometimes offset these low rates.
Borrowers can qualify for relatively large loans when they have sufficient equity. Your home equity might be the only source of funding available for large expenses like home improvements, higher education, or starting a business.
The Pitfalls of Home Equity Loans
The main problem with these loans is that you can lose your home if you fail to stick to the monthly payment schedule that your lender requires. If you fail to repay, the bank can foreclose on your home, taking your property and selling it to recover any unpaid funds.
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.
It can be tempting to use your home as an ATM because these loans can provide a lot of cash, but it’s best to reserve your home's equity for things that will improve its value, lead to a higher income for your family, or add significant value to your life. This doesn't include “wants” or luxuries.
Closing costs are also an issue. Borrowing against your home can cost thousands of dollars.
Be sure to repay your loans on time. If no payment is made, your assets will be at risk.
How to Get a Loan
Apply with several lenders and compare their costs, including interest rates. You can get loan estimates from several different sources, including a local loan originator, an online or national broker, or your preferred bank or credit union.
Lenders will check your credit and will require an appraisal, and it can take several weeks or more before they release any money.
Lenders commonly look for and base approval decisions on a few factors. You'll most likely need at least 14 percent equity in your property. You should have secure employment—at least as much as possible—and a solid income record even if you've changed jobs occasionally. You should have a debt-to-income (DTI) ratio of no more than 43 percent, although some lenders will consider DTI ratios of up to 50 percent. You'll probably also need a credit score of at least 620.
If You Have Poor Credit
Home equity loans can be easier to qualify for if you have bad credit because lenders have a way to manage their risk when your home is securing the loan. That said, approval is not guaranteed.
Collateral helps, but lenders have to be careful not to lend too much or they risk significant losses. It was extremely easy to get approved for first and second mortgages before 2007, but things have changed since the housing crisis and you can expect lenders to carefully evaluate your applications.
All mortgage loans typically require extensive documentation, and 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 have to provide proof of income, access to tax records, and more. They might require a lower than average DTI ratio if your credit is iffy.
Lenders 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 the home equity loan you’re applying for. The percentage of your home's available value is called the loan to value (LTV) ratio, and what's acceptable can vary from bank to bank. Some lenders allow LTV ratios above 80 percent, but yours will most likely have to be less if your credit is less than good.
Also keep in mind that your credit score is directly tied to how much interest you'll pay. The lower your score, the higher your interest rate is likely to be.
How to Find the Best Home Equity Loans
Finding the best home equity loan can save you thousands of dollars or more. Shop around to find the best deal. Different lenders have different loan programs available, and their fee structures can vary dramatically.
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’ll be paying the amount you expected.
Manage your credit scores and make sure your credit reports are accurate. Use rapid rescoring to get quick improvements that can lead to better rates if you find any errors or easy-to-fix issues in your credit reports.
Is it the right loan? Pause and make sure that this type of loan makes sense before you borrow. Is a home equity loan a better fit for your needs than a simple credit card account or an unsecured loan?
Figure it out before you put your home at risk if you're not sure. These other loans might come with higher interest rates, but you could still come out ahead by avoiding the closing costs of a home equity loan.
Make a detailed plan of your income and expenses—including this new loan payment—before you close on the loan. Include discretionary items that you might find difficult to give up, such as dining out occasionally. And keep in mind that the payments can increase over time if you have a variable rate.
If possible, consider waiting a while if your credit score is less than ideal. It can be difficult to get even a home equity loan if your score is below 620, so spend a little time trying to bring it up first if this is the case. This can include paying down revolving debt you're carrying to less than 30 percent of your credit limits. But don't close or cancel cards because this can negatively affect your credit.
Review your insurance coverage—life and disability in particular—and evaluate how you’ll cover the payments if something unexpected happens. You don’t have to buy the insurance that your lender will probably offer.
As with any other financial product, get quotes from a variety of sources, including online and independent insurance agents.
The Tax Factor
It was possible for some taxpayers to claim an itemized deduction for interest paid on home equity loans in tax years up to and including 2017. That deduction is no longer available as a result of the Tax Cuts and Jobs Act unless you use the money to "buy, build or substantially improve" your home, according to the Internal Revenue Service. Speak with a tax professional to find out how your home loans may affect your taxes.