Is a home equity loan a good idea?
If you own a home and need cash, a home equity loan might be a smart option. Home equity loans can help to cover large expenses like home repairs or medical bills. They typically have fixed interest rates and long repayment terms, which can make them more predictable and budget-friendly compared to other financing options.
But despite their perks, home equity loans aren’t right for every homeowner. If you’re wondering whether a home equity loan is a good idea, here’s what to know.
How a home equity loan works
Home equity loans let you borrow against the equity you’ve built up in your property. The equity in your home is calculated by subtracting your current mortgage balance from your home’s value.
You can typically borrow a certain percentage of your home’s value — usually 80% to 90%, depending on the lender. You’ll receive the funds as a lump sum that you can use however you’d like. You’ll then repay the loan in fixed installments with a repayment term that can range from five to 30 years.
When a home equity loan is a good idea
A home equity loan can be a good idea if you have a large, one-time expense that you can’t afford to pay for out of pocket. This kind of loan could also be helpful if you want to borrow money with a fixed interest rate that won’t change over time.
Like with any loan, make sure that you have room in your budget for a new monthly payment before you borrow and that you can comfortably afford it throughout the entire loan term.
When a home equity loan might NOT be a good idea
A home equity loan is a type of second mortgage, meaning it’s a loan you take out in addition to your main mortgage. This means you’ll be adding another monthly payment to your budget in addition to your primary mortgage payment.
For this reason, a home equity loan likely isn’t a good idea if you’re on a tight monthly budget or expect your income to decrease in the near future. This is especially important to consider because a home equity loan uses your house as collateral — so if you’re unable to make your payments, you could face foreclosure.
Taking out a home equity loan might also not be a good idea if you have a low credit score, excessive debt, or very little equity. These could make it hard to get approved or land you with less favorable rates and terms.
Pros and cons of a home equity loan
Here are some pros and cons to consider before applying for a home equity loan:
Pros
- Fixed interest rates and predictable payments
- Long repayment terms (typically 5 to 30 years)
- Lower interest rates than other borrowing options
Cons
- Uses your home as collateral, so you risk foreclosure if you can’t make your payments
- Adds a second monthly payment to your budget
- Reduces your home equity by adding another loan to your property
The big benefit of a home equity loan is that it allows you to borrow money with a fixed interest rate and pay it off with predictable payments over time. Repayment terms for home equity loans can be long (up to 30 years, depending on the lender). Rates on these loans are also typically lower than those of other borrowing options, such as personal loans and credit cards.
On the downside, home equity loans use your home as collateral, which means you could lose your house if you don’t make your payments. You’ll also be adding another payment to your budget as well as reducing the equity in your home, meaning you’ll have a lower profit if you choose to sell your home.
What to consider before getting a home equity loan
A home equity loan can put you at risk of foreclosure, so it’s important to weigh the decision carefully before committing to one. Here are a few things to keep in mind:
Your credit score
Your credit score will play a big role in not just your ability to qualify for a home equity loan, but what interest rate you get, too. The higher your credit score, the better your rate will be. While you can generally qualify for a home equity loan with a score of at least 620, having a score of 740 or higher can help you get more favorable rates.
While some lenders might accept lower scores, this usually results in getting a higher interest rate. This means you could have higher monthly payments, and you’ll also pay more in interest over time, which might strain your budget and make the long-term costs of the loan prohibitive.
How much home equity you have
The amount of equity you have impacts not only whether you can qualify for a home equity loan, but also how much you can borrow along the rate and terms you get. Typically, lenders will let you borrow 80% to 90% of your home’s value. This is calculated based on your combined loan-to-value (CLTV) ratio, which considers your primary mortgage balance as well as your desired home equity loan amount compared to your home’s appraised value.
If you have a low amount of equity, you either might not qualify or end up with a prohibitively high interest rate.
Your financial stability
You should also think about your financial stability, including how predictable your income is. You need to be able to cover your home equity loan’s monthly payments throughout your repayment term or else you risk foreclosure.
If you’re not sure you can comfortably manage an additional payment each month, this type of loan likely might not be a good idea.
Best uses of a home equity loan
You can use the proceeds for a home equity loan however you’d like. However, some expenses are can be a better fit for a home equity loan than others, such as:
- Home improvements: Using your home equity loan proceeds for home improvements can help to increase your house’s value and build your equity back up.
- Debt consolidation: Home equity loan rates are often lower than those of credit cards and other borrowing options. So consolidating your debt, or paying off high-interest debt with home equity loan proceeds, can help you save money on interest in the long run.
- Education costs: A home equity loan can also help you cover education costs if you’ve exhausted other options like scholarships or federal student loans.
- Medical bills: Medical care can be expensive, and it can often deter patients from getting the treatment or medicine they need. Home equity loans can be a good solution if you’re facing medical costs you can’t otherwise cover.
What you shouldn’t use a home equity loan on
It’s not a good idea to use a home equity loan for unnecessary expenses or discretionary purchases, like a vacation or new wardrobe. This type of loan uses your home as collateral, so it’s best to use the proceeds only for required costs or for expenses that could improve your financial situation in the long run.
Alternatives to a home equity loan
Home equity loans aren’t the only borrowing option you have. Here’s how home equity loans compare to some popular alternatives:
| Home equity loan | HELOC | Cash-out refinancing | Credit card | Personal loan | |
|---|---|---|---|---|---|
| Interest rates | Typically fixed | Typically variable | Fixed or variable | Typically variable | Typically fixed |
| Payout | Lump sum | Revolving credit line | Lump sum | Revolving credit line | Lump sum |
| Credit score requirement* | 620 or higher | 660 or higher | 580 or higher | 670 or higher | 670 or higher |
| Loan amounts | 80% to 90% of your home’s value (depending on the lender) | 80% to 90% of your home’s value (depending on the lender) | 80% to 90% of your home’s value (depending on the lender) | Credit limits vary by borrower and their credit profile | Up to $100,000 (depending on the lender) |
How a home equity loan affects your finances
It’s important to think about the impact a home equity loan would have on your overall financial picture before getting one. Some critical points to consider include:
- Monthly payments: A home equity loan requires fixed, monthly payments that must be paid on time, every time, to prevent foreclosure.
- Interest costs: A portion of your payments will go toward interest each month. By the end of your loan term, you could pay thousands or even tens of thousands in total interest.
- Debt load: Getting a home equity loan means taking on another debt, which will impact your credit and budget.
- Monthly cash flow: You’ll need to adjust your budget to make room for another payment. Also consider how taking out another loan could impact your current strategies for your savings, retirement, and investments (if applicable).
How to decide if a home equity loan is right for you
Whether a home equity loan is right for you depends on your needs and financial goals. Here are some important questions to ask yourself:
- Do you want a lump-sum payment? A home equity loan is paid out as a lump sum, which can be ideal for covering large expenses. However, if you don’t know exactly how much you need to borrow, a more flexible option — like a home equity line of credit (HELOC) — might be a better fit.
- Is your expense necessary, and will it improve your finances? If you’ll use the home equity loan proceeds to improve your house or consolidate high-interest debt, for example, then it could be a good idea.
- Can you commit to repayment for the long haul? Home equity loans require on-time monthly payments or you risk foreclosure. You’ll want to make sure your finances are stable and that you’ll have the funds both now and in the future to cover your payments.
Compare: HELOC vs. home equity loan
Using a home equity loan FAQs
The major risk of a home equity loan is that it uses your home as collateral. If you don’t make your payments, your lender can foreclose on your house. A home equity loan also adds a second monthly payment to your household, which might strain your budget.
It depends on what your needs and goals are. A home equity loan can be a good choice if you want a fixed interest rate and predictable monthly payments. But if you need repeated access to funds over time and can afford fluctuations in your payments, then a HELOC might be more ideal.
