The Pros and Cons of a Home Equity Loan
Home equity loans can be tricky. On one hand, they can help you get the cash you need. On the other, you’re using up the equity you’ve built up in our home. There are many reasons to get a home equity loan, but before you commit, you’ll want to know the benefits and disadvantages so you can choose whether it’s the best path for you and the equity you’ve built.
Do You Have Equity?
The percentage of your equity is based on two aspects:
- Loan-to-value ratio: The amount you currently owe compared to the current market value of your home.
- Current market value: If the current market value of your home is more than what you owe on your mortgage, you have a positive equity balance that you can borrow from. If, however, you owe more on your mortgage then it’s current market value, your equity percentage is non-existent, and qualifying for an equity loan is not an option.
Pros and Cons
Let’s take a look at some pros and cons of taking out a home equity loan.
Pro: Money for the things you need
There are lots of ways to use your home equity loan. From starting a business to smart investments to paying for your wedding, once your equity loan is approved, you’ll receive a lump sum to use however you want.
Pro and Con: Pay less interest
The interest on your home equity loan will be lower than getting a personal loan or borrowing a cash advance from one of your credit cards because the loan is secured in the eyes of the bank. In other words, your home is collateral.
However, keep in mind that this is also a disadvantage. While using your home for collateral lowers your interest, if you default on your loan, the bank may foreclose on you and take your house. Understand the risks before you make a decision.
Pro: Predictable payments
Because your interest rate will be fixed, creating a budget is easy and predictable. You won’t have to worry about your payment increasing due to changing interest rates.
Con: Costs and fees
Pro: Tax deductible
Interest you pay on up to $750,000 (for married couples) or $375,000 (individuals) borrowed through a home equity loan is tax deductible as long as you used the loans to buy, build or substantially improve your home.
Con: Cycle of debt
The major disadvantage many people don’t consider is that home equity loans feed the cycle of debt. Think about it. You spent all this time paying off your debt to build some equity in your home, only to take that money out and borrow against it again. At the end of the day, you’re not really ahead. You borrow so you can spend and the habit of spending sends you deeper into debt. If you’re going to do this, it better be for an important reason.
Is a Home Equity Loan the Best Choice for You?
Knowing if a home equity loan will best serve you will depend on your reasons for wanting one.
If you are a homeowner who sees an equity loan as a way to pay for holiday gifts, romantic getaways, or family vacations, you may want to think twice.
However, if you are a homeowner who can use the predictability of a home equity loan to budget wisely for a much-needed expense, a home equity may be just what you need.
Still undecided? Compare a home equity loan to a line of credit to help you decide.
“Although rising interest rates make it more costly to borrow, they have had little effect on home equity lending,” says Tendayi Kapfidze, chief economist at LendingTree. “This is because lending has been in decline since the financial crisis because of a reduction in risk appetite. Lenders have tightened lending standards significantly and borrowers are wary to borrow having overextended themselves leading into the financial crisis.” He says that “the total amount of revolving home equity loans outstanding has fallen to $360 billion from June 2018 from $611 billion in May 2009 and continues in a downward trend.”