Although inflation has eased slightly in recent months, the Federal Reserve’s continuous rate hikes, along with generally rising prices, continue to make everyday life more expensive. Homeowners who need access to cash may look to leverage their home’s equity with a home equity loan.
Borrowing against your house can be a more efficient and more affordable way to access capital than with a personal loan, so long as you have at least 15% to 20% equity built up in your property. However, the stakes are much higher -- if you default on your payments for a home equity loan, you risk losing your home.
It’s crucial to understand how a home equity loan works, and to examine the pros and cons so you can decide if it’s the right financial move for you.
What is a home equity loan?
The process of borrowing money with a home equity loan is similar to taking out a personal loan, except the loan is secured. A secured loan requires you to put something up as collateral in case you default on your payments. In this case, you use the difference between what your home is worth and what you owe on your mortgage as collateral.
A home equity loan offers you a one-time lump sum of cash, which you’ll pay back over the life of the loan. Home equity loans generally have fixed interest rates, meaning your monthly payments won’t change even if rates do.
Don’t confuse a home equity loan with a home equity line of credit or HELOC. A HELOC is more akin to a credit card. You have access to a revolving line of credit, meaning you can withdraw funds as needed. With a HELOC, you’ll only pay interest on what you’ve borrowed, but usually at a variable rate -- making it a potentially more risky option than a home equity loan.
Pros of home equity loans
Taking out a home equity loan can help you fund life expenses such as home renovations, higher education costs or unexpected emergencies. Home equity loans tend to have lower interest rates than other types of debt, which is a significant benefit in today’s rising interest rate environment.
A typical repayment period for a home equity loan can range anywhere from five to 30 years, depending on the terms set by your lender, which provides you with a generous period of time to pay back your loan.
A home equity loan offers you predictable monthly payments because your interest rate is fixed and never changes. You’re on a set repayment schedule and make the same monthly payment for your whole loan term. That’s different from a home equity line of credit, or HELOC, for example, which comes with a variable interest rate, which can cause your monthly payment to fluctuate depending on macroeconomic factors like inflation, job growth and actions taken by the Federal Reserve.
Lower interest rate than other types of financing
A home equity loan allows you to borrow against the equity you’ve built in your home, so it’s considered secured debt. Since there’s collateral to mitigate risk, this allows banks and lenders to offer you lower interest rates than with unsecured debt, like a personal loan or credit card. Right now, the average rate for a home equity loan is 8.00%, according to Bankrate, CNET’s sister site.
If you use your home equity loan to complete home renovations or improvements, you can deduct the interest from your taxes. Plus, if you use your home equity loan for property improvements, you may simultaneously increase the value of your property while enjoying the investment in your space while you live there.
Cons of home equity loans
The biggest downside to a home equity loan is that the bank can foreclose on your home if you default on your loan. There are also some cases when home equity loans might not be the best option. For example, if you’re planning to move soon, a home equity loan probably won’t make financial sense; without your home to secure the loan, you’re responsible for repaying the balance of your loan to your lender.
You can lose your home
Home equity loans often have lower interest rates than other types because they are secured debt. You must put up your home as collateral to secure the loan. If you miss payments or default on your loan, your lender has the power to repossess your property.
A lump-sum payment makes sense when you know exactly how much money you need, but if you’re working on a renovation project or have another situation where you need to draw on funds over time, a home equity loan doesn’t offer flexibility. Compare that to a HELOC, which lets you withdraw funds as needed instead. And while your rate will never increase with a home equity loan, if interest rates drop, your rate will remain the same and won’t decrease like a HELOC would.
You can end up upside-down on your mortgage
Although home prices rose more than 42% since the beginning of the pandemic, the impact of rising mortgage rates is starting to show as home prices begin to decline. If your property loses value and is worth less than you paid for it, and you’ve taken out a home equity loan in addition to your mortgage, you could end up with negative equity. Negative equity -- or being “underwater” or “upside-down” on your mortgage -- happens when you owe more on your mortgage than your house is actually worth.
Two mortgage payments
A home equity loan is commonly referred to as a second mortgage because it doesn’t replace your mortgage like a refinance – it’s a completely new loan that you must repay every month along with your current mortgage payment. You need to make sure you can comfortably and responsibly afford two monthly mortgage payments for the lifetime of both loans. As experts continue to predict a recession on the horizon, take stock of your savings, assets and employment situation to make sure your budget has enough flexibility to account for any unforeseen financial circumstances.
Tax deductible interest
Two mortgage payments
Alternatives to home equity loans
If a home equity loan doesn’t seem like the right move for you, there are other financing options to explore.
Home equity line of credit (HELOC)
There are a handful of alternatives to home equity loans, but the most obvious option is a HELOC, which functions as a line of credit against the home equity you’ve built, rather than a lump-sum loan.is also a loan you take out against the equity you’ve built in your home, but it is a revolving line of credit that functions similarly to a credit card. HELOCs also have variable interest rates, which means your monthly payments will go up and down depending on interest rate trends.
The average rate for a HELOC is currently 7.76%, which is below the 8.00% average rate for home equity loans. HELOCs offer more flexibility because you can repeatedly make withdrawals as needed. Plus, you can make interest-only payments during the draw period (usually 10 years), which allows you to make low, monthly payments for an extended period of time, unlike a home equity loan when you must start paying back your principal balance plus interest immediately.
A cash-out refinance replaces your existing mortgage with a new mortgage that has more favorable terms – namely a lower interest rate – and provides you with a lump sum of cash that is then added back onto the balance of your new mortgage. However, with mortgage rates significantly above the lows of 2020 and 2021, it’s unlikely a cash-out refi will make financial sense for most homeowners.
Personal loans and credit cards
Although personal loans and credit cards have higher interest rates, they come with less risk because you don’t have to put your home up as collateral to secure these types of financing. Right now, personal loans have an average rate of 10.81%, according to Bankrate. Using credit cards can also have additional benefits like earning rewards points or miles, but you must make sure you can manage high-interest consumer debt responsibility -- paying your monthly bill on time and in full -- if you choose to go that route.