When Is A Home Equity Loan A Good Idea?

If you’ve been paying your mortgage for a few years and see that your principal balance is down significantly compared to when you took out the loan, you may be wondering to yourself, “Is a home equity loan a good idea?"

A home equity loan can be a great way to leverage the value of your house to help with other financial goals you may have. At the same time, it’s not necessarily always the best course of action for everyone.

Here’s what you need to know about home equity loans so you can make the best decision for your unique financial situation.

To understand what a home equity loan is, you first need to understand home equity. Simply put, the amount of equity you have in your home is its current value minus what you still owe on your mortgage.

For example, let’s say you purchase a home for $300,000. You put 20% as a down payment, so you immediately have $60,000 in equity in your home once you complete the purchase. Your monthly mortgage payment then goes toward paying down the principal along with interest, taxes and insurance.

As you pay down part of your principal with each mortgage payment, your equity goes up. This happens for as long as you have the loan and assuming the value of your home stays steady or increases. Once you pay the loan off, you own your home free and clear, which means you can access 100% of the equity. 

Home equity loans can be a good way to help qualified borrowers achieve their financial goals, both related to their home and the rest of their finances. You can use your equity to fix or add on to your home, for example. In many cases, this might significantly increase the value of your home, thus increasing the equity.

Beyond the home, many borrowers use a home equity loan to consolidate debt or make other large purchases like a car, vacation or education. The options are endless, as there are no restrictions on what you can use the funds from your home equity loan for.

It’s important to consider the pros and cons of home equity loans related to your individual financial situation before deciding if applying for one is a good idea. Here are a few things to consider.

For some qualified borrowers, home equity loans can be a great way to increase the equity in their home. For example, if you take a $50,000 home equity loan out and make improvements to your house that increase the value by $75,000, you’ve just increased your equity by $25,000.  Not to mention that you’ve probably done something to improve your quality of life while you live in the home as well. New garage, anyone?

Debt consolidation can be another good reason to take out a home equity loan. Let’s say you have $50,000 in credit card debt over several different cards that averages 20% interest per month. If you paid those credit cards off with a $50,000 home equity loan that only has a 6% interest rate, you could cut your monthly interest payment drastically.

Pros Of Home Equity Loans

In addition to the home improvement, debt consolidation and other benefits of a home equity loan, there are other factors that make them a good idea compared to other loans. These include:

• Low, fixed interest rates
• Tax-deductible interest
• Easier qualification requirements than other types of loans

When you take out a home equity loan and use it for something that wouldn't directly increase your home's value or improve your overall financial situation, it may not be a good idea. Sure, cashing in on the equity you’ve built in your home to take a trip to Hawaii would be a blast. Financially speaking though, it’s probably not a good idea.

Cons Of Home Equity Loans

In addition to using the funds for the wrong reasons, there are a few other drawbacks to consider when deciding if a home equity loan is right for you, including:

• You could risk losing your home if you default on your loan
• You’ll have two mortgage payments: your original mortgage and the home equity loan
• You’ll pay closing costs

That depends. Every person or family’s financial situation and goals are different. While a home equity loan might make sense for some, it might be a bad idea for others. Each homeowner should carefully consider all relevant factors and their financial goals when deciding if a home equity loan is right for them.

Home equity loans aren’t the only way to get money out of the equity you have in your home. Here are a few other options to consider:

• Cash-out refinance: This is similar to a home equity loan, but the cash you take out is added to the principal balance of your original mortgage.
• Personal loans: A lending institution loans you money with a defined repayment period. These are usually not secured by collateral, so the interest rates are higher.
• Credit cards: Charging new expenses on your existing credit cards or opening a new one is an option. However, these interest rates are likely to be much higher than a home equity loan.
• Home equity line of credit (HELOC): This is like a home equity loan but serves as a line of credit that you can pay down and continue drawing on up to the defined limit, much like a credit card. Rocket Mortgage^® doesn’t currently offer these types of loans.

Hopefully you have a pretty good base understanding of home equity loans now, but some questions may remain. Let’s look at some FAQs about home equity loans.

What can the funds from a home equity loan be used for?

Many borrowers use a home equity loan to pay for home improvements, consolidate debt or pay for school tuition. That said, you can technically use a home equity loan for anything.

What’s the difference between a home equity loan and a home equity line of credit (HELOC)?

The difference between a home equity loan vs. a HELOC is that, with a home equity loan, you get a defined amount of cash and pay it back over time, with interest, as defined by the terms of the loan. A HELOC is a line of a certain amount of credit that you can draw on and pay down and then draw on again and so on.

Should I choose a home equity loan or HELOC?

That depends on your specific needs. Here’s a look at the pros and cons of each.

• HELOC
  
  • Pros:
    • Only pay if you use the funds
    • Low starting interest rate
    • Easier to qualify for
  • Cons:
    • Variable rate after the early part of the loan
    • Easy to spend more than you planned, like a credit card
    • If you don’t repay, you can lose your house
• Home Equity Loan
  
  • Pros:
    • Fixed rate
    • Clear and regular installment payments
  • Cons:
    • Higher closing costs than a HELOC
    • Repayment starts right away
    • If you don’t repay, you can lose your house

Home equity loans can be a great way to improve your home, consolidate debt, pay for school or help alleviate other financial strains on your budget. They can also be a path toward more debt if used for expenses that provide no financial short- or long-term gain. It all depends on your unique situation, so weigh the pros and cons to see if a home equity loan is right for you. Ready to get started? You can apply for a home equity loan today!