Is a home equity loan a good idea?

Home equity loans can be an enticing option if you’re a homeowner who needs to borrow money. They tend to have lower interest rates than those of personal loans and credit cards, and their fixed monthly payments can help you manage your budget. However, they also have downsides to consider.

If you’re wondering whether a home equity loan is a good idea for your situation, here’s what you should know.

What is a home equity loan?

A home equity loan is a type of second mortgage that lets you access the equity you’ve built in your home. Equity is the difference between your home’s current market value and the balance on your mortgage. You’ll receive the amount you borrow as a lump sum to use how you wish, and you’ll pay it back in fixed installments over a period of years. For example, you might get a home equity loan to cover the costs of home improvements, high-interest debt consolidation or a large purchase.

To be eligible for a home equity loan, you’ll typically need at least 20% equity in your home as well as a credit score of at least 680. You can generally borrow up to 85% of your combined loan-to-value ratio (CLTV), which is the ratio of all the loans secured by your home (such as your first mortgage) to the value of your property. Repayment terms range from five to 30 years.

Additionally, “home equity loans typically have lower interest rates than other loans (such as personal loans or credit cards) because they are secured,” says Allen Mueller, a chartered financial analyst and founder of 7 Saturdays Financial. “Secured loans are a lower risk to the lender than unsecured loans (like credit cards), and [the lender] can charge lower interest rates because of this reduced risk.”

Keep in mind that because a home equity loan is secured by your home, you risk it being foreclosed on if you can’t keep up with your payments.

When a home equity loan is a good idea (and when it’s not)

Whether a home equity loan is a good idea will depend on your individual situation. For example, taking out a home equity loan could be ideal if you:

• Know exactly how much you need to borrow and prefer receiving a lump sum payment. 
• Have good credit and can qualify for a competitive interest rate.
• Want several years to repay the debt.
• Will use the funds for home improvements that will raise the value of your house and increase your equity.
• Will be using the funds to “buy, build or substantially improve your home” and can qualify for a tax deduction.

However, a home equity loan might not be the best choice if you:

• Have recurring expenses or don’t know exactly how much you need to borrow.
• Want access to a revolving credit line to allow repeat borrowing rather than a one-time lump sum.
• Don’t qualify for a decent interest rate and the cost of borrowing will outweigh the loan’s benefits. 
• Can’t reasonably afford the monthly payments and might risk foreclosure.

Pros and cons of home equity loans

Pros

• Fixed rates and payments: Home equity loans usually have fixed interest rates. This means your rate and payment will stay the same throughout the life of the loan.
• Can have lower interest rates: Home equity loan interest rates are typically lower compared to the rates of unsecured loans like personal loans and credit cards. This is because the loan is secured with your property acting as collateral.
• Long repayment period: Home equity loan terms range from five to 30 years, which can be helpful if you want to spread out your repayment over a long period of time. Just keep in mind that the longer your term, the more you’ll pay in interest over the life of the loan.
• Flexible loan purposes: The funds from a home equity loan can be used for a variety of expenses, such as improving your home’s curb appeal or consolidating credit card debt.  
• Could be tax deductible: If you use the loan to make substantial home improvements, you might be able to deduct interest payments.

Cons

• Risk of foreclosure: Your house acts as collateral for a home equity loan — which means you could face foreclosure if you can’t make your payments. 
• Less accessible with bad credit: You’ll generally need a credit score of at least 680 to get approved for a home equity loan — though many lenders prefer a score of 720 or higher. While some lenders will accept lower scores than this, a home equity loan for bad credit could come with a higher interest rate, shorter term or lower loan amount compared to a good credit loan. 
• Requires sufficient equity: You can generally borrow up to 85% of your CLTV. If you haven’t paid off much of your first mortgage or have multiple liens on your property, you might not be able to borrow the amount you want.    
• Paid out as a lump sum: Receiving a lump sum means you’ll start paying interest on your entire loan balance as soon as you receive the funds upfront. Plus, if you need more funds, you’ll have to take out another loan. If you have recurring expenses or don’t know exactly how much money you need, a home equity line of credit (HELOC) might be a better option. 
• Closing costs can apply: Home equity loans often come with closing costs. These are usually 2% to 6% of the loan amount and can increase your overall borrowing expenses.

Home equity loan vs. HELOC: Which is better?

If you’re considering a home equity loan vs. a HELOC, here are some important points to keep in mind:

Alternatives to a home equity loan

If a home equity loan doesn’t seem like the right fit for your situation, here are some alternatives to consider:

• HELOC: Unlike a home equity loan, a HELOC is a revolving credit line that you can repeatedly draw on and pay off rather than receiving a single lump sum. Additionally, HELOCs sometimes come with a lower promotional rate for a period of time. However, keep in mind that HELOCs generally have variable interest rates that can fluctuate with market conditions.
• Cash-out refinance: This option lets you take out a larger loan to pay off your first mortgage and receive the difference to use how you’d like. Because you’re replacing your original loan, you’ll only have one rate and payment to manage. This could make a cash-out refinance a good choice if you can qualify for a competitive rate or want to switch from an adjustable rate to a fixed rate (or vice versa).
• Personal loan: Most personal loans are unsecured, which could make getting one a good option if you don’t want to use your home or other property as collateral. However, because of the additional risk to the lender, your interest rate on an unsecured personal loan will likely be higher than what you’d get on a home equity loan.
• Credit card: Like a HELOC, a credit card provides a revolving credit line that allows for repeated borrowing. Keep in mind that rates on credit cards tend to be higher than home equity loans and personal loans. Some cards provide a 0% annual percentage rate (APR) introductory period, which means you can avoid interest if you pay off your card before this period ends. However, if you can’t repay your balance in time, you could end up with some sizable interest charges.