Is a home equity loan right for you? Discover the pros and cons of this popular financial tool in this comprehensive guide.
Home equity loans have been steadily gaining popularity, and for good reason –– many homeowners have used home equity loans to eliminate high-interest credit card debt, finance college educations, pay off a personal loan, and even free up some cash to counteract the effects of inflation. But with hundreds of thousands of home equity loans issued each quarter of 2022, there’s a good chance that some of these borrowers won’t find the risk of a home equity loan worth the reward.1
Why? Because, for all their benefits, home equity loans still have plenty of disadvantages. And understanding these disadvantages can help you decide if the benefits outweigh the limitations (or if the opposite is true.) To help homeowners make the right decision for their financial futures, we’ve outlined the pros and cons of a home equity loan. Read on for a look at home equity loans, and decide if this popular financial tool is right for you.
If you’re just now learning about home equity loans, you’re not alone. You might be thinking: is a home equity loan a good idea? Although many homeowners have lived out their dreams or found a form of financial freedom by taking equity out of their homes using a home equity loan, conventional wisdom says a home is an investment –– and that their home’s equity will come in handy when it’s time to sell (or move into a different home). This makes definitively answering whether it’s a good idea to take equity out of your house a bit tough.
When you put down a downpayment or make a monthly payment toward your mortgage, you’re increasing your ownership stake of the property while decreasing your remaining balance: thus accruing equity. If you pay off your mortgage and decide to sell, this mountain of equity can be applied toward your next home, put into a high-interest savings account, or spent any way you choose. Even if you have a balance left on your mortgage when you sell, you can still walk away from the sale with some equity in hand.
But through tools like a home equity line of credit (HELOC) or a home equity loan, you can access this equity before selling: taking out a home equity line of credit or loan, and borrowing against your available equity. Spending this equity can be seen as counterintuitive for those who believe a home is an investment. But for those with no plans to sell, their home’s equity may look more like a savings account than an investment.
With that said, taking equity out of your home comes at a cost –– with both HELOCs and home equity loans coming equipped with interest fees. When comparing a HELOC vs home equity loan, the latter typically offers fixed interest rates, which can help curb both unpredictability and costs. But even at a fixed rate, a 20-year home equity loan can accrue tens of thousands in interest over the loan’s term.
Understanding the extensive pros and cons of a home equity loan will help you make the best financial decision for your future. Below is a comprehensive look at all of a home equity loan’s benefits, as well as its many limitations.
Through a home equity loan, homeowners can unlock the potentially hundreds of thousands of dollars in value that they have accrued with their mortgage’s maturity. Better yet: homeowners can do this without selling their homes. By accessing this equity without selling your home or refinancing your primary mortgage, you can use the funds to accomplish expensive home repairs –– reinvesting in the property and raising its value.
As we mentioned above, HELOCs and cash-out refinances can bring with them unpredictable interest rates. Home equity loans, on the other hand, generally come with fixed interest rates where the interest payment remains the same for the life of the loan.2 This stability helps borrowers know exactly what they’ll be paying each month to service the loan, making it easier to budget the monthly payment and set long-term financial goals while also protecting homeowners from fluctuations in interest rates. Learn how to secure the best home equity loan rate to get the most out of your equity.
Depending on where you live, interest paid on a home equity loan may be tax deductible, resulting in additional cost savings for eligible borrowers.3 Beyond geographic limitations, loans must meet IRS standards to qualify for tax deductions. To fully understand your specific deductions and any potential impact on your overall tax liability, we recommend you consult a qualified tax professional.
While many homeowners use home equity loans to get ahead –– tackling home renovations and reinvesting in the property –– others use this tool to keep from falling behind. In the event of a financial emergency, home equity loans generally offer a lower interest rate than credit card debt or a personal loan. This makes them a more cost-effective option for borrowers in need of a quick cash infusion, ensuring that borrowers don’t dig themselves into a financial hole just to maintain daily expenses.
With that said, home equity loans also allow debt consolidation where borrowers consolidate high-interest debts –– like the kind attached to credit cards and personal loans –– into a single, more manageable loan, potentially saving them thousands on interest in the process. Whether as a last-ditch effort for financial emergencies or as part of a long-term financial strategy, using home equity loans for debt consolidation can be extremely valuable.
For homeowners with no immediate plans to sell their home, home equity loans can help free up home equity and open doors to investment opportunities. This might mean an investment in education (in the form of a college fund) or the capital to fund a business opportunity. Whichever way you choose to leverage your equity, a home equity loan can help.
Despite their many benefits, it’s also important to consider the potential risks of home equity loans. Understanding the downsides can help you decide whether or not a home equity loan is the best option for you.
Home equity loans are secured loans, which means the loan itself is secured against your home. For many borrowers, this is simply too great of a risk to take.
Borrowers who access home equity using a home equity loan may have up to 30 years to pay the loan off, reducing monthly payments and providing added flexibility. But while longer repayment terms can lead to lower monthly payments, this extended period means more interest paid over the long term. This may result in higher overall interest costs compared to shorter-term loans, impacting the total amount borrowers repay over the life of the loan.
Home equity loans are sometimes called “second mortgages,” but in reality, mortgages typically feature better interest rates.4 Homeowners looking into home equity loans should carefully consider the overall cost of borrowing and be sure it fits into their long-term financial plans.
As with a primary mortgage, home equity loans often require a good credit score, proof of steady income, and a lower debt-to-income ratio. But unlike a mortgage, home equity loans also require homeowners to possess a certain amount of home equity. Therefore, borrowers with a poor credit score, unstable income, or lower home equity may find it challenging to qualify for a home equity loan –– or simply end up saddled with a high-interest loan. For those considering a home equity loan with bad credit, consider rebuilding your credit first.
While the home equity loan has more than its fair share of perks, its list of limitations is equally long –– and whether this popular financial tool poses a greater risk or benefit comes down to your financial situation. But as we mentioned above, there are other ways to accomplish similar goals. And if HELOCs or cash-out refinances aren’t for you, you might want to consider Truehold’s sell and stay transaction.
Here’s how it works. You sell your home and cash out your home equity, then continue to live in your home as a renter. We cover property tax, property insurance, and essential repairs. Tackle debts, travel the world, or take your time while you shop for your dream home –– the choice is entirely yours.
To learn more about Truehold’s sell and stay transaction, contact us today.
Sources:
1. Bankrate. Home Equity Loans on the rise in 2023. https://www.bankrate.com/home-equity/why-borrowers-keep-leveraging-equity/
2. Bank of America. Home equity loan vs. line of credit? Here’s what you need to know. https://www.bankofamerica.com/mortgage/learn/home-equity-loan-vs-line-of-credit/
3. Rocket Mortgage. Are Home Equity Loans Tax Deductible? https://www.rocketmortgage.com/learn/are-home-equity-loans-tax-deductible
4. Bankrate. Mortgage vs. home equity loan: What is the difference? https://www.bankrate.com/mortgages/mortgage-vs-home-equity-loan/
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