Deciding Whether a Home Equity Loan is Your Fit
As you gradually build equity by owning and maintaining a mortgaged home, you can use that equity for collateral to get a “second mortgage” — a lump-sum loan that you repay in monthly installments. The ability to leverage home equity loans gives borrowers beneficial, often cost-reducing options. However, there are drawbacks that you can run into unknowingly.
Let’s take a look at both sides of the coin.
Pros of Home Equity Loans
Lower Interest Rates Than Unsecured Loans
Your successfully mortgaged home (aka home equity) is now a security that you can show to lenders to get approved for new loans. Moreover, your home equity can help you get a loan at much lower rates than personal loans or credit cards. You can also consolidate a high-interest debt or finance some large, planned expense.
How exactly do home equity loans work?
You get to shop for lower borrowing costs because you have your existing property as collateral and, as opposed to unsecured loans, lenders can assume less risk with your new equity loan.
If you need to borrow a large amount, you can save on the total interest with the equity loan. As for the debt consolidation — if you have several high-interest credit balances, you can consolidate them into a single fixed-rate home equity loan and simplify repayments.
Predictable Fixed Monthly Payments
Unlike HELOC loans (which are revolving credit lines that usually have a variable rate), a home equity loan locks in both the interest rate and monthly payment. Again, this can be leveraged to simplify long-term budgeting.
The predictability of the repayment term gives you payment certainty, which allows you to manage household expenses, plan retirement, or balance multiple financial goals much more insightfully.
Knowing exactly how much you'll owe each month, you won’t be as shocked by regular, rising payments (especially if you’re a homeowner on a fixed single income or simply can’t afford even long-term financial instability).
Large Borrowing Amounts
When applying for a home equity loan, you can shoot for much capital to borrow at once (as opposed to unsecured loans). The loan amount will be shaped by the size of your accumulated home equity.
Instead of putting all focus on your income or credit, lenders will be scrupulously evaluating your existing home and the amount of equity that it has accumulated.
The purpose of this large-sum loan availability is to help qualified borrowers finance projects that would be difficult to cover with a personal loan, e.g., renovating an older home, purchasing improvements for investment property, or consolidating multiple home debts (as mentioned above).
Ideal for One-Time Expenses
A home equity loan is the way to go for cases where you know the exact amount you'll need long before actually borrowing. Since you receive the full loan proceeds in one lump sum, it's an efficient solution for projects or expenses where you have a clearly defined budget.
Common home equity loan-based financing cases include:
- Big home renovations and/or additions
- Roof replacement or structural repairs
- Kitchen or bathroom remodeling
- College tuition
- Medical expenses
- Debt consolidation
- Business startup or expansion
- Large one-time purchase
Potential Tax Benefits
In certain situations, a home equity loan may provide tax advantages on top of all the financing benefits you get. However, simply using your home's equity as collateral isn’t enough to make any related interest deductible.
Under current IRS rules: You can make the interest paid on a home equity loan tax-deductible if you use the money that you borrow to buy, build, or improve the home that secures the loan (and if you itemize all deductions).
For some particular examples, you can use a home equity loan to:
- add a room
- replace a roof
- remodel a kitchen
- install a new HVAC system
All of the above expenses will qualify if you use the resulting improved equity to secure the loan, reporting it straight to the lender. For best individual decisions, it’s best to consult a tax specialist here.
Cons of Home Equity Loans
You Put Your Home on the Line to Secure Debt
It’s sort of a double-edged sword — see, with home equity loans, failing to make payments doesn’t simply damage your credit score. Missing payments can ultimately result in foreclosure (because the lender has a legal claim against your property).
With your home as the collateral, the property you put down works as an asset that grants long-term financial security. Potential foreclosures can be too risky, so you’re best off considering home equity loans only when you have the emergency budget in hand.
Home Equity can Shrink During Market Downturns
Every dollar you borrow against equity decreases your ownership stake (thus reducing the same accumulated equity). And while that may not seem important if you don't plan to sell anytime soon, lower equity can affect your financial flexibility in several ways.
For example, less equity means:
- less cash available if you decide to sell your home
- reduced borrowing capacity for future financing
- a smaller financial cushion if property values decline
- a slightly higher combined loan-to-value ratio
If housing prices fall after you've borrowed heavily against your equity, you could find yourself with little remaining ownership stake.
Closing Costs can Reduce the Value of Smaller Loans
Although home equity loans generally cost less than many unsecured financing options over time, they aren't free to obtain. Like a primary mortgage, they can incur upfront expenses and closing costs, like appraisal fees, title searches, recording fees, lender origination charges, document preparation, etc.
These costs can total serious sums (bigger for larger loan amounts and less secure lenders). These upfront expenses are one reason home equity loans are usually better suited for larger borrowing needs.
Make sure to compare the loan’s total cost with potential expenses before signing.
Less Flexibility Than a HELOC
You get one lump sum. So if you need extra funds later on, instead of using the same account to draw more money, your only option will be to submit for yet another new loan.
In turn, a HELOC's revolving credit line allows borrowers to withdraw funds as needed, potentially reducing interest costs by borrowing only what is required at each stage. Choose the right mechanism based on whether your financing needs are fixed or evolving.
No-Go for Ongoing or Discretionary Spending
A home equity loan isn’t good for ongoing or unpredictable expenses because you begin paying interest on the full balance immediately. If renovation costs may change over time or you're unsure how much funding you'll ultimately require, a HELOC's revolving credit structure may offer greater flexibility.
The same goes for using home equity to finance discretionary spending, such as vacations, luxury purchases, or lifestyle expenses. That way, you may convert unsecured consumer debt into debt secured by your home, which you surely don’t want to happen.
How LBC Mortgage Can Help You
Not sure if a home equity loan is for you? LBC Mortgage will help analyze your situation, consult the next best equity-related decisions, and personalize your journey through a feature-rich platform.