Is A Home Equity Loan A Good Idea?
January 31, 2024 6-minute read
Author: Carey Chesney
If you’ve been paying your current mortgage for a few years and see that the 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 every homeowner.
Here’s what you need to know about home equity loans so you can decide whether this type of loan is right for your financial situation.
What Is Home Equity?
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 equal to its current value minus what you still owe on your mortgage.
For example, let’s say you purchase a home for $300,000. You make a 20% 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, assuming the value of your home stays steady or increases. Once you pay off the loan, you own your home free and clear, which means you can access 100% of the home equity.
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Are Home Equity Loans A Good Idea?
A home equity loan lets you borrow a lump sum of money against the equity in your home, and pay it back with fixed monthly payments over the life of the loan. 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 financial profile. You can use home equity to renovate your home, for example. In many cases, this could significantly increase the value of your home, thus increasing the equity.
Beyond home improvements, many borrowers can 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. Below, we’ll get into some of the factors you may want to consider before taking out a home equity loan.
When Are Home Equity Loans A Good Idea?
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.
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 renovation, debt consolidation and other benefits of a home equity loan, there are other factors that can make them a good idea compared to other loans. These include:
- Lower interest rates at a fixed rate
- Tax-deductible interest
- Easier qualification requirements than other types of loans
When Are Home Equity Loans Not A Good Idea?
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 vacation would be a blast. Financially speaking though, it’s probably not the best 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 in a foreclosure 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.
Should I Get A Home Equity Loan?
Whether you should take out a home equity loan depends on your situation. Every person or family’s finances and goals are different. While a home equity loan might make sense for some, it might be a bad idea for others.
If you’re thinking about taking out a home equity loan, you’ll first need to qualify. Your lender will consider personal factors like your credit report, credit score, loan-to-value ratio (LTV) and debt-to-income ratio (DTI). If you have less-than-favorable credit or a high DTI, you may want to work on your qualifying factors in order to secure a better interest rate and loan terms.
You’ll also need to get a home appraisal before taking out a home equity loan. The home appraisal determines how much money you can borrow against your home’s equity. Once you’re approved, you’ll have to pay closing costs and other fees, like an origination fee, when you close on the loan.
Each homeowner should carefully consider all relevant factors and their financial goals when deciding if a home equity loan is right for them.
What Are Some Alternatives To Home Equity Loans?
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: A cash-out refinance is similar to a home equity loan, but the cash you take out is added to the principal loan balance of your original mortgage.
- Personal loan: Personal loans are different from home equity loans in that a lender allows you to borrow money with a defined repayment period. Personal loans are usually not secured by collateral, which results in higher interest rates.
- Credit card: Charging new expenses on your existing credit cards or opening a new one is also an option. However, these interest rates are likely to be much higher than a home equity loan.
- Home equity line of credit (HELOC): A HELOC 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 HELOCs.
See how much cash you could get from your home.
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Is Getting A Home Equity Loan A Good Idea? FAQs
Hopefully you have a pretty good base understanding of home equity loans now, but some questions may remain. Let’s look at some FAQs that can help you determine whether a home equity loan is the best choice for you.
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.
Is a home equity loan a second mortgage?
A home equity loan is considered a second mortgage because you have to make monthly payments toward the home equity loan amount, in addition to your primary mortgage payments.
What’s the difference between a home equity loan and a HELOC?
The difference between a home equity loan and 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 loan terms. 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?
Whether you should take out a HELOC or a home equity loan depends on your specific needs. Here’s a look at the pros and cons of each.
HELOC Pros And Cons
You only have to pay if you use the funds
Variable interest rate after the early part of the loan
Low starting interest rate
Easy to spend more than you planned, like a credit card
Typically easier to qualify for
If you don’t repay, your mortgage lender could seize your property
Home Equity Loan Pros And Cons
Fixed interest rate
Higher closing costs than a HELOC
Interest may be tax-deductible
Loan repayment starts right away
Clear and regular installment payments
If you don’t repay, you can lose your house
The Bottom Line
Home equity loans can be a great way to improve your home, consolidate debt, pay for student loans or help alleviate other financial strains on your budget. On the flip side, a home equity loan can also lead to more debt if the lump sum is used to cover 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.
Are you ready to get started? You can apply for a home equity loan today!
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