Pros and Cons of Home Equity Loans

Your home can be one of the most valuable sources of wealth you'll have in your lifetime, representing years — sometimes decades — of hard work and savings. Because of its immense personal and financial value, a house can often be used as collateral for other purchases. One way to do this is by using the monetary worth you've built up for your home to obtain a home equity loan.

Applying for this type of loan is a big decision, and you should consider major home equity loan pros and cons beforehand. Even if you managed to avoid the biggest mortgage mistakes made by homeowners, you should know about potential home equity loan mistakes. While it's wise to consult a financial advisor to see if a home equity loan is advantageous for your situation, we'll help explain the basics of different types of equity loans, how they work, what they're best used for, and what can happen if you fail to pay off the loan.

What is a Home Equity Loan?

Also called a HEL, second lien, or second mortgage, a home equity loan allows you to borrow cash based on the equity you've built in your home. Equity is the value of the portion of your home that you actually own. If you've paid off your mortgage or own your home outright, your equity would be the entire value of your home. If you haven't yet paid off your mortgage, your lender still owns part of your home until you pay off the remaining balance. In that case, your home's equity would be the value of your home minus your remaining mortgage balance.

A home equity loan lets you exchange the value of your ownership for cash. Once you pay off the loan, the ownership of that value returns to you. The amount of time you have to repay the loan varies. The loan also typically includes upfront costs to borrow the money, and the additional debt can slightly lower your credit score. If you're still making mortgage payments on your home, they will not be affected by a home equity loan.

Pro tip: Check out our blog to learn how to increase your credit score for an upcoming loan.

What Happens if You Default on a Home Equity Loan?

One of the biggest home equity loan cons is that, in exchange for cash, the lender owns a stake in your home until you repay the loan. If you default on your HEL, the lender can foreclose on your home and auction it off to recover its losses, even if the sale price is much higher than the money you owe.

For some homeowners, this can be a huge gamble with their most significant financial asset. That's why meeting with a credit counselor or financial advisor can help you determine if you can pay off the loan without running into trouble and potentially losing your home. You should also consider whether your plans for the loan, like using a home equity loan to build a new house, will allow you to pay back all the money you owe.

Home Equity Loan Pros and Cons

Compared to traditional bank loans, home equity loan cons and pros can be higher risk and higher reward. Discussing the following benefits and drawbacks with a financial advisor is an excellent idea before speaking to a lender.

Home Equity Loan Pros

• Because you're using your home as collateral, you may be able to get a loan for more money than you could with a personal bank loan.
• They typically have a fixed interest rate that's often lower than what you'd get with a personal loan.
• If used for improvements and renovations that increase the value of your home, the interest may be tax deductible. Consult a tax advisor or the IRS rules for more information.
• The repayment period can be from 5 to 30 years.
• HELs typically have lower credit score and debt-to-income requirements than personal loans.

Home Equity Loan Cons

• If you can't make regularly scheduled payments or pay the loan in full, you can lose your home.
• To use your home as collateral, you must have at least 15% to 20% equity in the property.
• You'll have to pay closing costs for the loan.
• If you have a mortgage, you'll make two monthly loan payments.
• HELs can take longer to be approved than personal loans.
• If your property value declines while repaying the loan, you could owe more than your home is worth.
• If you use the loan funds to pay personal living expenses or credit card debt (instead of home improvements or renovations), the interest is likely not tax deductible. Refer to current IRS regulations for current guidelines.

Find the Right Fit for Your Loan

As with any loan, the home equity loan pros should be weighed against your ability to pay it back — particularly considering that defaulting could cost you your home. It’s usually wiser to spend your equity loan on things that can increase your home’s value, like home improvement or remodeling investments.

Using the loan proceeds to pay off other debt may help your financial situation but know that your house is the collateral and would be in danger of being foreclosed if you don’t repay the loan.

One of the most ill-advised uses for an equity loan is to purchase luxury items with no financial returns, like cars or vacations. Also, spending the money on risky investment opportunities, including using a home equity loan to build a new house, can put your home at peril. These choices can gamble away the financial and personal security your current home provides.

Learn More: Visit our blog to find out which home updates are worth the work.

HELOC vs. Home Equity Loan

Technically, a HELOC, or home equity line of credit, is a type of home equity loan. When homeowners consider a home equity loan, they typically compare a HELOC to a fixed-rate home equity loan. While both allow you to borrow cash against your home's equity, a fixed-rate HEL is paid out in a lump sum. In contrast, a HELOC allows you to make multiple withdrawals throughout a "draw period" — typically 10 years — using special credit cards or checks. The draw period is followed by a repayment period — typically 20 years — in which you'll have to pay off the loan.

With a HELOC, you only pay interest on the money you borrow. And, as the name implies, a fixed-rate HEL has a set interest rate that you'll pay on the loan, while a HELOC typically has a variable interest rate that can fluctuate over the loan term.

Which of these different types of equity loans are right for you? Here's a rundown of HELOC pros and cons:

HELOC Pros

• You can borrow money repeatedly during the draw period if you continually pay down the loan balance.
• You only pay interest on the money you withdraw.
• Multiple withdrawals over the draw period can be better for long-term projects with uncertain costs.
• These loans typically have lower upfront costs and fees, depending on the lender.

HELOC Cons

• A variable interest rate means you could pay higher interest rates than initially considered due to market fluctuations.
• Monthly loan payments can vary, making it hard to plan.
• Obtaining a HELOC lowers the overall equity of your home.
• Since loan terms for HELOCs are typically long, sometimes decades, they're not a good fit if you plan to move in the future.

Is a Home Equity Loan Right for You?

Now that you've learned about different types of equity loans and reviewed home equity loan pros and cons, you should speak to a financial advisor or credit counselor to decide if a fixed-rate home equity loan or home equity line of credit is right for you. First, ask whether simply saving or taking out a personal loan would be better for you.

If you need a larger sum, inquire about a cash-out refinance on your mortgage, which allows you to increase your mortgage loan amount and provides extra money for your projects.

Make sure you discuss the home equity loan cons you've learned about so that you choose the right option for you — one that provides the money you need but won't put ownership of your house in jeopardy. 

Protect Your Investment with a Home Warranty

You’ve worked hard for your home; protect it with a home warranty. A home warranty from First American can help save you money when unexpected breakdowns occur. Protecting your home’s appliances and systems also means protecting your budget so you can continue to build your wealth. Ready to get coverage? Get a free home warranty quote today or check out our home warranty guide for new home buyers.

The contents of this article are provided for general guidance only. First American Home Warranty does not assume any responsibility for losses or damages as a result of using this information.