When you need money in a pinch, borrowing against your home may be a viable solution. But there are pros and cons to taking out a home equity loan. Here's how to decide whether tapping the equity in your home is the right way to go.
What is a home equity loan?
A home equity loan is a loan in which the lender uses your home as collateral to let you borrow money. If you can’t repay your loan, your lender can seize your property to get its money back. On the up side, they're easy to qualify for and usually have low interest rates.
To determine how much equity you have, you'll need to see what your home is worth and compare that number to your outstanding mortgage balance. The difference is your equity.
For example, if your home is valued at $200,000 and you owe $150,000 on your mortgage loan, you have $50,000 of equity in that property. That's 25% equity. Generally, you need at least 20% equity to borrow against your home with a home equity loan or home equity line of credit (HELOC).
Your home equity loan works just like any other loan -- you pay back the principal amount you borrowed and interest at a fixed rate over a preset period until your balance is gone.
Benefits of a home equity loan
One major advantage of using the equity in your home to secure a loan is that it’s easy to qualify. If you have equity, a lender will generally approve your loan application, knowing it can use your home as collateral. With an unsecured loan, like a personal loan, you won’t qualify unless you have a good credit score because there’s no collateral.
Not only are home equity loans easy to qualify for, but they also tend to come with low interest rates. As such, they’re an affordable way to borrow. Credit cards and personal loans, on the other hand, tend to charge higher interest rates.
Home equity loans are also flexible -- you’re not limited to home improvements or repairs. You can take out a home equity loan to help pay for college, for example. The only catch is that if you use your home equity loan for a purpose other than improving your property, you won’t be eligible to deduct the loan interest on your taxes. But you can’t deduct most types of loan interest, so that’s not really a deal breaker.
Drawbacks of a home equity loan
Although there are plenty of good reasons to take out a home equity loan, there are some negatives as well. First of all, if you don't make your payments, you risk losing your home. That's serious business.
Furthermore, you may run into problems if you have an outstanding home equity loan but need to sell your home. Although you are allowed to put your home up for sale with an outstanding loan attached to it, you'll need to sell it for a high enough price to pay off your balance. If you don't, you'll need to negotiate with your lender to resolve the issue at hand, which could involve converting your home equity loan to a different type of loan with less favorable terms.
Also, having a home equity loan in place could mean facing certain restrictions on your home. For example, your lender might prohibit you from renting out your home while that loan is being repaid.
Alternatives to a home equity loan
A home equity loan isn't your only option when you need cash. Another option to consider is a HELOC, which gives you access to money that you can tap during a predetermined draw period. The upside of this route is that you're not committing to borrowing the entire sum, so you don't automatically have to start paying interest on it.
Imagine you're looking at what you think will be a $30,000 home repair. If you take out a $30,000 home equity loan, you'll be on the hook for interest on that entire $30,000. However, if you secure a $30,000 HELOC, but your repair only winds up costing $25,000, you'll avoid paying interest on the remaining $5,000 (assuming you don't borrow it for another purpose).
Another route you can take when you need money is a cash-out refinance. This involves refinancing your mortgage to a new loan -- ideally, one with a lower interest rate. But you borrow more than the sum of your outstanding home loan balance. That way, you get the difference in cash and use that money as you please.
For example, if you owe $150,000 on your mortgage but do a cash-out refinance, you might take out a new loan worth $180,000. The first $150,000 of that will replace your existing mortgage balance, but the remaining $30,000 can be given to you so you can use it immediately.
Is a home equity loan right for you?
Because there are pros and cons to taking out a home equity loan, your best bet may be to price out a few different financing options and see which makes the most sense.
If you have a steady job and borrow a reasonable amount against your home, the concern of falling behind on those loan payments and losing your home may not be so pressing, in which case a home equity loan could be your most affordable ticket to accessing the cash you need. Weigh your options carefully before rushing to sign those papers.