A home equity loan can be a good idea if you're a homeowner who has at least 15% to 20% equity built up in your property and you need access to low interest-financing. But home equity loans also come with risks that are important to understand when deciding if one is right for you.
Home values have risen substantially over the past two years, making home equity loans -- which provide you with a lump sum of cash at a fixed interest-rate -- an appealing option for many.
Pros of home equity loans
Taking out a home equity loan can be a good idea if you need money to 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 are on a set repayment schedule and will 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 gives you a variable interest rate, meaning your monthly payment can 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, allowing banks and lenders to offer your lower interest rates than other kinds of financing like personal loans or credit cards. Right now, the average rate for a home equity loan is 7.26%, according to Bankrate, CNET's sister site.
If you use your home equity loan to complete home renovations or improvements, the interest is tax-deductible. Plus, if you use your home equity loan for property improvements, you may be simultaneously increasing the value of your property while being able to enjoy the investment in your space while you live there.
Cons of home equity loans
The biggest downside to a home equity loan is that your home can be foreclosed on if you default on your loan, but there are also some cases when home equity loans don't make much sense. 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 are responsible for paying back 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 is great when you know exactly how much money you'll need, but if you end up needing additional cash for any reason, a home equity loan doesn't offer you any flexibility for receiving more funds. Compare that to a HELOC, which lets you withdraw funds as needed and doesn't require you to take the full lump sum like a home equity loan. If interest rates go down for any reason, a home equity loan is also less advantageous because your rate will remain the same and won't decrease like your HELOC rate 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 if 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 what 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.
Alternatives to home equity loans
There are a handful of alternatives to home equity loans, but the most obvious option is a HELOC, which 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.
Home equity line of credit (HELOC)
Although the average rate for a HELOC is currently 7.34%, which is slightly higher than the 7.26% 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 at 14-year highs, 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 11.08%, 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 if you choose to go that route.
The bottom line
A home equity loan can be a smart way to borrow against your home equity and access funds at a relatively low interest rate, but you must put up your home as collateral to secure the loan. A home equity loan is essentially a second mortgage you take out against your home and can be used to fund major life expenses like home renovations (which are tax deductible) and college tuition. Home equity loans have fixed-interest rates which makes them an attractive loan product as interest rates continue rising and inflation persists.