One of the benefits of home ownership is that you can tap into the equity in your property and use it as collateral for a loan when money is needed to pay for large expenses like home renovations. or debt consolidation. Funded in a lump sum and repaid over five to 30 years at a fixed interest rate, home equity loans can be a good choice for these types of large cash flow needs.
However, there are also a few drawbacks to consider before proceeding with a home equity loan. Here are the pros and cons of home equity loans.
Main advantages of home equity loans
Those who obtain home equity loans can find several advantages over other forms of borrowing.
Unlike a Home Equity Line of Credit (HELOC), which has a variable interest rate that can rise unexpectedly at any time, the interest rate on a home equity loan is fixed for the term of the loan.
âWhen you take out a home equity loan, up front, you’ll know exactly how much you’ll have to pay off each month and what the interest rate will be,â says Sam Eberts, junior partner at financial services firm Dugan. Brown.
Lower interest rates
In addition to offering a stable interest rate, because home equity loans are secured by your property, they usually offer a lower rate than unsecured forms of borrowing such as personal loans or credit cards. .
âWhile you can pay closing costs or other fees, it’s an inexpensive alternative to an unsecured loan,â says Laura Sterling of Georgia’s Own Credit Union.
Long repayment terms
The repayment terms for home equity loans can be up to 20 years. This fact, coupled with lower interest rates than unsecured loans, can result in a very affordable monthly repayment.
Interest which may be tax deductible
Another potential benefit of home equity loans is the tax deduction. Interest paid on a home equity loan can be tax deductible up to $ 100,000 if you use the money to significantly improve the property used to secure the loan, explains Sterling. âSince there are limits on what you can deduct, it’s always best to consult your tax advisor,â explains Sterling.
Main disadvantages of home equity loans
While there are many advantages to using a home equity loan for large expenses, you should also consider the disadvantages before taking out this type of loan:
- You could lose your home. Because your home is being used as collateral for the loan, if you default, you risk losing your home.
âIf you don’t pay off your home equity loan, your financial institution could foreclose on your home,â explains Sterling. Likewise, if the value of your home goes down, you could owe more on your home than it is worth, making it difficult to sell.
- You will need good to excellent credit. While it is true that home equity loans generally offer lower interest rates than unsecured loans or credit cards, the most competitive rates are given to borrowers with good to excellent credit.
- You must have substantial equity in your home. To qualify for a home equity loan, you generally need to have between 15 and 20 percent of the equity in your property.
- If you sell your home, you are responsible for the loan balance. A home equity loan is tied to your home. If you choose to sell the house, you will have to repay the loan.
âIn many cases, you may be able to use the proceeds from the sale of your home to pay off both loans,â explains Sterling. “However, if the value of your home goes down or if you are upside down on your home, it could put you in a bad financial position.”
Who are home equity loans for?
In general, home equity loans are best for borrowers who need to cover large costs or purchases and know in advance exactly how much money will be needed. These types of loans are also a particularly attractive option for those looking to make improvements to their home.
âIf a renovation is done correctly, the home’s value will rise above the loan amount, creating even more equity in the home,â says Steve Sexton, financial consultant and CEO of Sexton Advisory Group. “Plus, the borrower can write off the interest on his taxes because he used the proceeds to renovate his house.”
Home equity loans vs HELOCs
A home equity loan and home equity line of credit (HELOC) use your home as collateral when you borrow money. However, there are also many differences between these two financial products, so it’s important to do your research and understand which one is really right for your needs and financial situation.
Home equity loan
A home equity loan is dispersed in a lump sum, making it a good choice for those who know exactly how much to borrow. Plus, this option comes with a fixed interest rate for the life of the loan and fixed monthly payments, which can be a safer bet for those on a tight budget.
âHome equity loans give you the security of knowing your exact monthly payments,â says Sterling of Georgia’s Own.
A HELOC is a revolving line of credit similar to a credit card. You can borrow from a HELOC as needed during its drawdown period, which typically lasts about 10 years. After that you enter the repayment period.
A HELOC has various advantages, including the fact that you are only responsible for paying back what is borrowed. HELOCs can be a good choice if you don’t have clearly defined borrowing needs or if you have expensive ongoing projects and will need access to cash over an extended period of time.
However, one of the biggest drawbacks of a HELOC is that it comes with a variable interest rate that can rise unexpectedly. âYou could find yourself stuck paying higher interest rates while simultaneously having to make your regular mortgage payments,â says Eberts of Dugan Brown.
Also, if not used responsibly or if you lack discipline, it is possible to accumulate more debt during the drawdown period than you can reasonably afford to pay.
Home equity loans can be a useful option if you know how much you want to borrow and are more comfortable with a fixed monthly payment and a fixed interest rate than a variable rate. However, you need to think carefully about whether you are comfortable using your home as collateral before proceeding with this type of loan, remembering that if for some reason you default you could lose your home.