For homeowners who are looking to tap into their home’s equity for extra cash, a home equity loan might be a good option. However, this type of loan also comes with risks to keep in mind, such as the possibility of losing your home if you don’t keep up with your monthly payments.
Here’s what you should know before getting a home equity loan.
What Is a Home Equity Loan?
A home equity loan is essentially a second mortgage that lets you borrow against your home’s equity, which is the difference between what your home is worth and what you still owe on your first mortgage. This can help you access extra cash if you need it.
How Does a Home Equity Loan Work?
Home equity loans are offered by a variety of mortgage lenders. Like with most loans, you’ll usually need good to excellent credit (meaning a credit score of at least 680) as well as a stable income and a low debt-to-income (DTI) ratio to qualify for a home equity loan. You must also have enough equity in your home—typically at least 20%.
You can generally borrow up to 80% or 85% of your home’s value with a home equity loan, depending on the lender and your financial profile. If you’re approved, you’ll receive a lump sum to use how you wish—for example, to cover large expenses like home improvements or unexpected medical bills.
Home equity loans come with fixed interest rates, meaning you’ll make payments to cover both the principal and the interest in fixed installments over the lifetime of the loan. Repayment terms generally range from five to 30 years. Keep in mind that lenders usually offer better rates to borrowers who opt for shorter terms.
When to Get a Home Equity Loan
Here are a few situations that could make getting a home equity loan a good idea:
- You can qualify for a good interest rate. Because a home equity loan is secured by your house and is therefore less risky for the lender, it will typically come with a lower interest rate than you’d get on an unsecured personal loan or credit card. If you have a good credit score, you’ll have a better chance of qualifying for the lowest rates available, which will reduce your overall loan cost.
- You know exactly how much you need to borrow. Unlike a home equity line of credit (HELOC), a home equity loan is paid out as a lump sum. This could be helpful if you know exactly how much you need to borrow.
- You want stable payments. Because home equity loans come with fixed rates, your payments won’t fluctuate like they could with a variable-rate HELOC or credit card.
- You’ll qualify for a tax deduction. You can deduct home equity loan interest from your federal income taxes if you use the funds to “buy, build, or substantially improve your home,” according to the IRS.
When Not to Get a Home Equity Loan
While a home equity loan can be a good option in some cases, getting one comes with several risks that are important to be aware of. If you’re considering a home equity loan, here are some scenarios where it might be better to look into other alternatives:
- You could risk losing your home. In addition to however much you still owe on your first mortgage, taking out a home equity loan means you’ll have another large loan to repay at the same time. And like with a typical mortgage, your lender could seize your house if you fail to make your payments. If there’s any question that you’ll be able to manage two loans, don’t get a home equity loan.
- You’ll have to pay high closing costs. Like with your first mortgage, you’ll have to pay closing costs if you take out a home equity loan. These can range from 2% to 5% of your loan amount, which could significantly eat into your cash reserves.
- You don’t know how much you need to borrow. If you end up needing more money than what you borrowed with a home equity loan, you’ll have to apply for another loan. In this case, it might be better to go with a revolving credit line that allows you to repeatedly borrow, such as a HELOC.
- You’re thinking about selling your home soon. If you decide to sell your house, you’ll have to make enough from the proceeds of the sale to settle both your first mortgage as well as your home equity loan. This could leave you with very little—or even zero—cash proceeds from the transaction.
Alternatives to a Home Equity Loan
Here are some alternatives to consider if a home equity loan doesn’t seem like the right fit for you.
- HELOC: Unlike a home equity loan, a HELOC is a revolving credit line that you can repeatedly draw on and pay off. This could be a good option if you have a long project with fluctuating costs to cover. Keep in mind that like a home equity loan, a HELOC is secured by your house, and you risk foreclosure if you don’t make your payments.
- Personal loan: With a personal loan, you can typically borrow up to $100,000, depending on the lender. Most personal loans are unsecured, which makes them less risky for the borrower than a home equity loan. However, the tradeoff is that you’ll likely have a higher interest rate.
- Credit card: Another revolving credit line option is a credit card. Some cards come with a 0% annual percentage rate (APR) introductory offer, which means you could avoid paying interest if you repay your card before this period ends. But if you can’t pay off the card in time, you could be stuck with high interest charges—and interest rates on credit cards are typically higher than rates on both home equity loans and personal loans.
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