Becoming a homeowner is a central personal finance goal for many individuals and families. In addition to creating stability, it also allows you to build up equity as you repay your mortgage. A home equity loan will allow you to dip into this asset in order to access financing, and it can thus be an avenue to secure a relatively cheap loan. However, there are sharp downsides to pursuing this route. Understanding the pros and cons is essential before you decide to take a home equity loan.
How Do Home Equity Loans Work?
A home equity loan is similar to other types of financing, with the key distinction being that you will use the part of the house you own as collateral. The amount of the potential loan you will qualify for is, therefore, based on the value of the equity that you have accumulated.
The amount of equity in your home is essentially the value of the portion of the house that you own. This depends both on the status of your mortgage and the value of your house. A simple way to understand this is by taking the amount you owe on your mortgage and subtracting this figure from the value of your home. For example, if your home is worth $400,000 and you have $100,000 remaining on your mortgage, you own $300,000 worth of equity in your house ($400,000 – $100,000 = $300,000).
Lenders will base the amount of the loan they will offer you on the amount of equity that you have accumulated, generally up to 80-85% of the value of your equity stake. The financing offered will function similarly to a fixed-rate mortgage, and you will pay back your loan in regular installments until both the principal and interest are paid off.
For this reason, home equity loans are often referred to as a second mortgage. In that sense, your home will not fully be yours until you have paid off both your mortgage and any home equity loans that you elect to take.
What Are the Advantages of Home Equity Loans?
The principal advantage of a home equity loan is that it is usually an easier loan to qualify for. Because your house is a valuable asset, banks and other lenders are more likely to approve your loan. The terms and conditions will depend on the amount you are seeking, along with your credit score and financial circumstances.
The interest rate and repayment terms tend to be more lenient than unsecured loans, especially if there are some negative blips on your credit history. This will allow you to access predictable, consistent interest rates, along with longer repayment periods.
Another advantage of a home equity loan is that the interest payments are tax deductible if you are using the funds to make home improvements or repairs to your home. This has the additional benefit of making your house more valuable as well.
What Are the Downsides of Home Equity Loans?
Using your home as an anchor for financing comes with a fairly large risk: if you are unable to repay your loan, the lender could foreclose on your house.
For those individuals who are fairly comfortable with their income streams, this may not be a huge concern. However, circumstances can change, and the upshot of a home equity loan is that you are endangering your residence if you suddenly find yourself without the means to repay your obligation.
Moreover, because it is a relatively easier source of financing to secure, it can also lead to taking on more debt. Though freeing yourself from high-interest credit card debt is a worthy goal, it will also increase the available credit you will have at your disposal. Some people will interpret this as an opportunity to keep on spending beyond their abilities.
This phenomenon is known as “reloading,” and it occurs when you use loan monies to pay off other debts and then go on to acquire additional obligations. If you lack the self-control to rein in your spending, this can lead to a spiral of debt (particularly consumer debt) which gets increasingly difficult to escape from.
Should You Take a Home Equity Loan?
Whether or not you decide to take a home equity loan should depend on a number of different factors.
The first is the value of the equity that you have built up in your home. If you have only recently bought your house using a mortgage, chances are that you have yet to accumulate a meaningful amount of equity. Adding another loan (i.e., a second mortgage) on top of your initial mortgage is probably not a great idea–even if you could find a lender willing to provide these funds.
The second factor to consider is what you are planning on using the funds for. Making home improvements certainly has its benefits (both by increasing the value of your home and by potentially lessening your tax burden), though it could be more advantageous to pay for this work through the cash you have on hand.
Paying for education or high-interest credit card debt are also common uses of home equity loans. While there are merits for both, there may be other options to pay for education, including public student loans, which have a number of built-in advantages. Paying off your credit card obligations with a low-interest loan can help you escape from the vicious cycle of high-interest debt, though this only makes sense if you have the wherewithal to ensure that you do not repeat your past overspending.
Lastly, make sure you consider your financial situation. This includes your current and future income streams as well as your other liabilities. You should also take into account your natural proclivities and whether or not you have the self-control to avoid spending beyond your means.
Conclusion: Understanding Your Options
A home equity loan uses your house as collateral to help you access financing. While it can be a cheaper option than other types of loans, you also put your house at risk of foreclosure if you are unable to pay it back.
Therefore, a home equity loan can be one of the possibilities that you consider if you need to gain access to funds. However, before using your home equity to secure a loan, make sure to understand how this option stacks up against other potential sources of funds.
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