Pros and Cons of a Home Equity Loan

Americans are sitting on record high levels of home equity: $9.9 million at the end of 2021, according to research firm Black Knight. With all that equity, many are considering tapping into it with a home equity loan. We'll walk you through the advantages and disadvantages of a home equity loan.

Key Takeaways

  • Home equity loans allow you to access cash at a cheaper rate than many alternatives.
  • They are quick to obtain, which can be both good and bad for borrowers.
  • With higher interest rates, home equity loans come with higher payments. 
  • If you can’t afford to repay your home equity loan, you could lose your home.

What Is a Home Equity Loan?

A home equity loan is exactly what it sounds like: a loan that allows you to borrow against the equity you have in your home. While loan products do vary across lenders, most home equity loans will pay out an agreed-upon lump sum and you will pay back that loan over fixed, equal monthly payments over a set period of time until the loan is paid off. By using your equity as collateral, home equity loans allow you to access larger sums of cash at a much lower interest rate than other unsecured forms of debt, like credit cards and personal loans, as long as you have enough equity in your home.

Calculating Your Home’s Equity

You can calculate your home’s equity by taking the current value of your home and subtracting the balance of any loans you have on it. Then, divide that figure by the current value of your home. Let’s say you have a home valued at $400,000 with a $200,000 mortgage balance and no other loans against the home: $400,000 - $200,000 = $200,000. Then, $200,000 divided by $400,000 (your home’s value) is 50%. Congrats, you have 50% equity in your hypothetical home!

Pros of a Home Equity Loan

  • A fixed interest rate with set monthly payments for a fixed period of time.
  • Lower interest rates than many other common forms of debt.
  • Easy-to-obtain large sums of money you may not qualify for through other avenues.

Cons of a Home Equity Loan

  • A lump sum payment means you may take out more than you need, spending the excess money frivolously and eroding your home’s value in the process. 
  • Risks include foreclosure and becoming underwater on your loans, meaning you can’t afford to move or sell your home if your home’s value decreases. 
  • You might take on more debt payments than you may be able to keep up with in the future.

Interest Rates Rising

For much of the last decade, interest rates have been incredibly low but this era appears to be ending as the Federal Reserve has increased interest rates multiple times so far in 2022. Home equity loans still carried risks, but were relatively cheap with low payments. As interest rates rise, borrowing against your home’s equity means larger payments that may be harder to accommodate if your income decreases.

Do All Home Equity Loans Have Fees?

No, not all home equity loans have fees. Some lenders charge different fees depending on the amount of the home equity loan and some have zero fees for any home equity loans. As with any loan product, shop around to make sure you’re getting the best deal.

What Are Alternatives to a Home Equity Loan?

Alternatives to a home equity loan depend on the amount needed and the purpose of the loan. The greatest alternative to a home equity loan is an emergency fund or delaying an expense and budgeting to save for it in advance but that’s not always possible. For a small amount, a 0% APR credit card is a great alternative, but make sure you pay it off before the promotional interest period is up. For a larger amount a cash-out refinance may be a better option.

Can You Get a Home Equity Loan Without a Mortgage?

Yes, you can get a home equity loan whether or not you have a mortgage. If your home is mortgage-free, then you definitely have enough equity in your home for a home equity loan as long as you meet the other lending requirements.

What Are the Requirements to Be Approved for a Home Equity Loan?

Individual lending requirements will vary, but in general you’ll need a minimum of 10% equity in your home, with most lenders requiring 15% or more. In addition to having sufficient equity you’ll also need all the normal things that come with applying for a loan: proof of income, decent credit, and a good debt-to-income (DTI) ratio. In general the credit score and DTI requirements for a home equity loan are slightly more lenient than for unsecured debt like a credit card as the loan is backed by an asset.

The Bottom Line

Home equity loans have long been used as a way for borrowers to access large sums of cash for relatively low interest payments. As interest rates rise, home equity loans are still a cheaper option than other forms of debt because they carry the risk of losing your home if you can’t keep up with payments. Make sure what you’re taking out the home equity loan for is worth the risk.

Article Sources

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