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The Pros and Cons of a Home Equity Loan

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For many homeowners, converting home equity into cash with a home equity loan can be a cost-effective way to achieve certain financial goals. Before reaching out to a lender, though, it’s important to fully understand the pros and cons of a home equity loan.

What is a home equity loan?

A home equity loan is a type of second mortgage that allows you to tap the available equity — the difference between your home’s value and your mortgage balance — in your home. The loan is paid out in a lump sum and is secured by your home. You’ll typically repay the loan in fixed installments over a term of five to 30 years.

It’s called a second mortgage because if you lose your home to a foreclosure sale, your home equity lender would be second in line to be repaid, after the lender who provided the first mortgage you used to buy your home.

Lenders may have stricter home equity loan requirements, such as higher credit score minimums and less flexibility for higher debt-to-income ratios. Plus, your loan-to-value (LTV) ratio should be 85% or lower, meaning you still have at least 15% equity in your home after tapping equity.

Pros and cons of a home equity loan

Before filling out an application, take the time to review the pros and cons of a home equity loan.

Pros

  • You’ll pay a fixed interest rate. One of the main benefits of a home equity loan is whether interest rates rise or fall, your monthly payments won’t be affected because your rate is fixed for the life of the loan.
  • You’ll have lower borrowing costs. Interest rates on home equity loans are typically lower than rates for unsecured personal loans or credit cards, because your home is used as collateral.
  • You can use the money for virtually any purpose. You have the freedom to use your loan to buy an investment property, start a business or fund another goal. Some reasons for using a home equity loan may be wiser than others, but once you’re approved, you can use the lump sum for almost anything.
  • Your interest payments may be tax-deductible. If you use your home equity loan to make improvements to the home securing that loan, you may qualify to deduct your interest payments from your taxable income.

Cons

  • You’ll pay higher rates than you would for a HELOC. Rates on home equity loans are usually higher than they are for home equity lines of credit (HELOCs), because your rate is fixed for the life of your loan and won’t fluctuate with the market as HELOC rates do.
  • Your home is used as collateral. If you stop making payments on your home equity loan, you could lose your home to foreclosure.
  • You’ll pay closing costs. Home equity loans typically come with closing costs and fees, which range from 2% to 5% of the loan amount. You may be able to roll these into the loan, but these costs should be taken into account when you’re comparing your options.
  • You’ll have two mortgage payments. If you’re still repaying your first mortgage, you’re now responsible for juggling two housing-related payments each month, which reduces your disposable income and could slow down your savings or other financial goals.

Differences between HELOC and home equity loan

A HELOC is a revolving credit line rather than a lump sum. It works similar to a credit card and has a credit limit that can be reused as it’s repaid. You only make payments based on what you owe, plus interest. Let’s take a quick look at the differences between a home equity loan and line of credit.

Home Equity Loan Home Equity Line of Credit
Provided in a lump sum Provided on a credit line
Fixed interest rate Typically has a variable interest rate
Payments required after loan is disbursed Payments typically required after draw period ends
Repay full amount of loan, plus interest Repay only what you use, plus interest
Secured by your home Secured by your home

3 alternatives to a home equity loan

Cash-out refinance

A cash-out refinance replaces your existing mortgage with one that is larger than your outstanding loan balance. You’ll receive the difference between the two loans in cash.

If mortgage rates are now lower than the rate on your existing mortgage, a cash-out refinance can lower the cost of borrowing while allowing you to access cash from your home equity. On the flip side, you could pay more in interest over the life of the loan, especially if you’re extending your repayment term.

HELOC

A HELOC gives you access to a set line of credit that you can borrow against over and over again during the loan’s borrowing period. HELOCs typically have a draw period, a fixed length of time, such as 10 years, during which you can access funds.

You may be required to make interest-only payments during the draw period. Once the draw period is over, you enter the repayment period and your credit line access ends. You’ll make principal and interest payments until your balance is paid in full.

Unsecured personal loan

An unsecured personal loan allows you to borrow money and repay it in fixed installments over a set repayment schedule. You may qualify for a loan amount up to $100,000 and a loan term of up to 10 years.

Keep in mind that personal loan rates are often higher than home equity loans or HELOCs, since the loan isn’t secured by an asset like a home or car. The average interest rate for a borrower with an excellent credit score is 10%, according to companion site ValuePenguin.

 

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