A home equity loan is a great way to turn the equity you hold in your property into ready cash, but it does come with some long-term consequences for your home. We take a look at the pros and cons of a home equity loan.
Home Truths: Home Equity Loan Pros and Cons
Being a homeowner these days can feel a bit like being “all ranch, no hat.” You’re the proud owner of a fine property and you’re doing everything you can to pay down your mortgage, but finding the ready cash you need for other important expenses always seems to be a struggle.
A home equity loan allows you to turn some of the “cattle” you already own into actual dollars by borrowing against the portion of your mortgage you have already paid off. It’s a great way to free up much-needed money while still continuing to build your stake in your most valuable asset—your home.
The lump sum payment from a home equity loan can be used for anything you want, including fancy headgear. However, because you’re borrowing against the stake you hold in your home, you need to be cautious about how you use this hard-earned money and are fully committed to paying it back—while also making your mortgage payments.
Here we take a look at how home equity loans work and some of the main pros and cons of taking money out of your house to cover other expenses. We also consider some smart things to spend your home equity loan on, including home improvements and debt consolidation.
How Do Home Equity Loans Work?
The equity in your home is the difference between your mortgage balance and the market value of your home. If you have been paying your mortgage for a couple of years and the value of your home has increased, you likely already hold significant equity.
Most lenders will not extend a home equity loan until you have paid off at least 15-20% of your mortgage. Usually, you can also borrow only 75-80% of the value of your equity. This is known as the loan-to-value ratio of your loan.
In other words, if you have repaid a quarter of your mortgage on a home worth $400,000, you have $100,000 in equity and a potential loan-to-value ratio of 25%. A lender willing to allow you to borrow against 80% of your equity would then give you a loan amount of $80,000.
Once approved, a home equity loan gives you a lump sum payout that can be used for anything you wish. Like your mortgage, your home equity loan is secured by your home itself. As a result, interest on home equity loans is relatively low. Home equity loans can also be repaid over longer periods than unsecured loans, sometimes over up to 30 years.
Let’s take a closer look at some of the major advantages and potential disadvantages of this type of lending.
Advantages of Home Equity Loans
Home equity loans can be a smart and sustainable way to cover major expenses when borrowed responsibly and spent wisely.
Cash in Hand
Depending on your equity stake in your property, a home equity loan allows you to free up a large amount of cash at one time to cover major life expenses. The money is paid out as a single lump sum and can theoretically be used for anything you wish, although it’s best to use it for something that will build wealth over time in the same way your equity does.
As secured borrowing, home equity loans offer annual percentage rates close to those of mortgages. This is lower than you will get on an unsecured personal loan and far lower than the variable interest rates available on credit cards or other forms of short-term borrowing. Best of all, home equity loan rates are fixed, so you know exactly how much interest you will pay.
Low Monthly Payments
The lengths of a home equity loan—anything from five to thirty years—mean that your monthly payments will remain relatively low for the full life of your loan, even with a higher interest rate. Unlike a home equity line of credit, the fixed interest rate also means you will always pay the same amount.
Interest payments on home equity loans to improve or upgrade a home are tax deductible. That makes this type of loan a smart and efficient way to add value to a property, especially the same home that you are borrowing against.
Your Equity Stays in Place
One of the best things about home equity loans is that you borrow against your equity stake, rather than “liquidating” your equity by selling or refinancing your home. While it may be tough to repay both a home equity loan and a mortgage, this means your original equity stake will continue to increase along with the overall value of your property.
Disadvantages of Home Equity Loans
At the same time, tapping your home equity loan does have some serious implications for both your personal finances and the long-term value of your property.
Bigger Debt Load
By taking on a home equity loan you will increase your debt load for years to come. You will pay a substantial premium on your loan principal and interest over this time and you will need to be able to keep up with payments both on your loan and your original mortgage.
Applying for a home equity loan involves many of the same costs as applying for your original mortgage including application, origination, title search, and appraisal costs. You’ll also need to be ready to pay closing costs of anywhere between 2-5% of the total value of your loan. This may make it uneconomical to take out a smaller home equity loan.
Harder to Sell
While borrowing against your equity can be good if home prices rise, if your home falls in value you could end up owing more than your equity is worth. An “underwater” home equity loan could see you taking a big loss if you are forced to sell your home before property prices improve or you are able to complete upgrades to increase its value.
Risk of Home Loss
By using your home as collateral for both your home equity loan and your mortgage, you are increasing your risk of losing the home you live in if you cannot keep up with payments or default on either of your loans. While that may seem unlikely now, remember that your financial circumstances may change over time and put you in a compromising position.
How to Get a Home Equity Loan
Applying and qualifying for a home equity loan has many similarities to when you took out your original mortgage, although approvals can be much quicker than for a full mortgage.
Key steps in the process include:
- Check your credit score: This will give you some idea of how likely most lenders will be to give you a loan. Try to improve your score by paying off some of your smaller debts.
- Apply for a loan: Complete and submit paperwork, along with details of your income, assets, and outstanding debts as well as provide details on why you want a loan.
- Pay fees: Pay any application, title check, or processing fees plus possible fees for an appraisal of the value of your home.
- Close on your loan: Sign documents and pay any closing costs or other fees.
Popular Uses of a Home Equity Loan
When you take out a home equity loan, you are borrowing against the equity that you worked hard to build up. For that reason, it’s wise to invest the cash from your loan in things that will grow in value over time or open up new opportunities for you or your family. Let’s take a look at some of the most popular uses for home loans.
This is the best possible use for your home equity funds, especially if you reinvest the money in the property you are borrowing against. Not only are the interest payments on loan funds spent on home improvement tax deductible, but by increasing the value of your home you will also grow the value of your equity while you pay back your loan.
Paying for College
Investing in your children’s future can be a smart move that can pay off richly in the future, especially if they can enter the workforce debt free. However, this might not be a wise move if you are relying on your home equity loan to fund your own retirement.
While tapping the hard-earned value of your home equity to pay off short-term debts may not be a smart deal, if you are able to replace multiple high-interest payments every month with a single, lower payment over years, you may be able to free up your time and resources to build wealth in other ways.
However, be careful that the significant costs of taking out a high-interest loan do not outweigh any savings you might make on interest payments.
No one likes to think about it, but unexpected medical emergencies or illnesses can set you back years financially. A home equity loan can help you spread out the financial load of hospital treatments or long-term care for a family member or loved one.
Buying Another Property
It is even possible to use the lump sum payment from a home equity loan to help you take the next step on the property ladder by funding a down payment for a condo, cabin, or second home—provided the property is mainly for your own personal use.
Greater Texas Credit Union: Come Home to Value
Your home is not just where you hang your hat—it’s your single most valuable asset. Your own property provides you with security and value you can take to the bank. Using a low-interest home equity loan to consolidate your debt means you can pay off other debt you may owe over time in easy, predictable payments while continuing to work hard to grow the value of your property, raise your family, and get ahead in life.
Greater Texas Credit Union home equity loans offer:
- Low rates
- Rapid approval
- Tax deductible interest (when used to pay for home improvements)
We’re always ready to sit down with you to understand where you’re coming from and where you want to go. Talk to us about how a home equity loan could save you money on your higher-interest debt or click below to learn more.