Pros and Cons of Home Equity Loans
Home equity loans are a type of second mortgage which let you borrow money against the current value of your home.
If you’ve built up enough equity, then you can take one out against your home’s value. Home equity is the difference between your home’s current value and the outstanding balance on your original mortgage.
These are commonly used when people need to pay for a large expense, including debt consolidation, home improvement projects, business funding, and more.
What We’ll Cover
- Pros and Cons of Home Equity Loans
- How Home Equity Loans Work
- Home Equity Loans vs. Home Equity LInes of Credit
- How to Get a Home Equity Loan
Pros and Cons of Home Equity Loans
Home equity loans often make sense for people who need a lump sum of money for large purchases.
However, as with anything else, they have their pros and cons.
Pros of Home Equity Loans
They have a number of great advantages, including:
Low Interest Rates: They are secured by your property, so they typically have lower interest rates than unsecured debts.
Tax Deductions: You might be able to deduct the amount you pay in interest if the balance is used for home improvement purposes.
Fixed Payments: They generally have a fixed payment schedule.
Borrowing Limit: The borrowing limit can be very large as long as you have enough equity to cover it.
Overall, these products are often a much better option than personal oblgiations when you need a large sum of money.
Cons of Home Equity Loans
While these can be a great option, they are not without their disadvantages. Some of these cons include:
Risk: If you fail to make payments you may lose your home to foreclosure.
Closing Costs: Unlike personal types, you’ll have to pay closing costs. These can be quite expensive.
Selling Your Home: Since these are secured by your home, you’ll be required to immediately pay off your balance in its entirety if you sell your home. Meaning you’ll have to pay off your first and second mortgage all at once.
Despite these risks, these can be a great way to get access to a large sum of money with great repayment terms.
How Home Equity Loans Work
To see how they work, let’s take a look at a quick example.
Say you originally borrowed $200,000 to purchase your home. Now, after making payments for a while, your mortgage balance has dropped to $100,000. Also in the time since you bought your home, its value has increased to $250,000.
In this case, you would be able to borrow up to $150,000 against your home’s equity, as that’s the difference between your mortgage balance and your home’s value.
If approved, you would be able to borrow this amount in cash to be repaid over time.
Keep in mind that you use your home as collateral. This makes these debts easier to qualify for, but also makes them riskier for borrowers.
Home Equity Loans vs. Home Equity Lines of Credit
When looking for these products, you might also see mention of home equity lines of credit (HELOCs). Both can be great options, but it’s important to understand the differences.
As mentioned above, they allow you to borrow a lump sum of money to be repaid over a predetermined amount of time with a set interest rate — just like any other debt.
Alternatively, a HELOC is more like using a credit card. You’ll be given a line of credit (the limit of which is, at most, the total equity), and you can borrow as much as you need up to that amount. This option is generally more flexible as you only have to pay interest on the money that you actually use.
HELOCs generally have variable interest rates, whereas home equity loans often have fixed interest rates.
How to Get a Home Equity Loan
Obtaining one doesn’t need to be a difficult process. There are just a few steps you should take before applying.
Calculate Your Equity
First and foremost, you need to calculate your home equity. If you don’t have any equity, or you only have a little bit, this may not be an option.
Home equity is simply the value of your home minus what you owe on your mortgage. The amount that you can borrow is based on your loan-to-value ratio.
If you need help calculating your equity, you can use a home equity calculator.
Know Your Credit Score
Like with any other debt, your credit score is an incredibly important factor.
Your credit score will determine how much you can borrow, your interest rates, and your term.
For these, you’ll often be required to have a credit score of at least 620.
Find a Lender
Finding the right lender for you is the most important part of this process.
The most crucial aspect of shopping for lenders is to compare offers from as many lenders as possible. This will help ensure that you find the best rates and terms available.
Be sure to explore all of your options, including private lenders and credit unions. Banks are the most common choice, but don’t necessarily offer the best terms.
If you’re not sure where to start looking, you can check out Bankrate’s list of the best home rates.
After you find the right lender for you, all you need to do is fill out and submit your application. The application will typically consist of basic financial information, such as:
If your application is approved, you’ll be given an offer which dictates your interest rate and term.
If you are happy with these terms, all you have to do is close the deal to receive your money.
Frequently Asked Questions
Are there any alternatives?
HELOCs are one of the primary alternatives. Instead of receiving a lump sum of money, you can borrow as little or as much as you need, up to the limit of your line of credit.
Alternatively, you can consider cash-out refinancing. This involves replacing your current mortgage with a new mortgage based on your home’s increased value.
Home much equity do I need?
Every lender will have its own requirements, so be sure to ask your lender how much equity is required in order to be approved.
Generally, you should aim for at least 15% to 20%.
What if I have bad credit?
Fortunately, these are still obtainable if you have bad credit.
Since they are secured by your property, they are much easier to be approved for, even if your credit isn’t the best.