Is a Home Equity Loan a Good Idea?

According to Federal Reserve data, the market value of homes in the U.S. has increased by approximately 47% since 2014. While this is bad news for homebuyers, it means many homeowners have amassed considerable home equity. 

You might consider a home equity loan if your home is worth much more than your outstanding mortgage balance. But is a home equity loan a good idea, or is an alternative better? Here are the biggest benefits and drawbacks of home equity loans and several potential alternatives to consider if you plan to finance a large expense. 

Benefits of a home equity loan

• Flexible use: You can use a home equity loan for almost anything, including home renovations, medical bills, emergency expenses, and more, making it an attractive financing option for many homeowners. 
• Fixed rate: Most home equity loans have fixed interest rates, so your rate won’t go up in the future—and neither will your monthly payments. 
• Lower rate than many alternatives: While rates for home equity loans have increased recently, they’re still lower than those of several alternatives, such as credit cards. 
• Potential for large loan: If you have significant equity in your home, you might qualify for a large home equity loan. 
• Long repayment terms available: A home equity loan could have a repayment term as long as 30 years. A longer term means lower monthly payments, though you will pay higher interest costs over the life of your loan. 
• Possible tax deduction: You used to be able to deduct interest on a home equity loan no matter the loan’s purpose. But changes to the tax code only allow you to deduct interest if you use the loan to buy, build, or substantially improve the property you took the loan against, and you must itemize your deductions rather than claim the standard deduction. Still, this could result in a helpful tax deduction, provided that you use loan funds for a major home improvement project.

Downsides of a home equity loan

• Requires significant equity: While you might have significant equity in your home if you bought it 10 years ago, the same may not be true if you bought it two or three years ago. You’ll generally need at least 15% or 20% equity in your home to qualify for a home equity loan. 
• Home is collateral: Your home is collateral for a home equity loan. Thus, your lender can take your house if your financial situation changes and you can’t make your monthly loan payments. 
• Rate won’t decrease: Some types of financing, such as home equity lines of credit (HELOCs), tend to have variable rates. With variable-rate financing, your interest rate can decrease due to broader market conditions, though it could also increase. Because most home equity loans have fixed rates, your interest rate won’t decrease. 
• Potential for going underwater: Another potential risk is that if the real estate market declines, you could end up underwater on a home equity loan. For instance, if the value of your $400,000 home decreases to $350,000, it could put you at risk of owing more than your house is worth after totaling your original mortgage and your home equity loan. 
• In-depth application and approval process: Certain types of financing, such as personal loans and credit cards, have simple application and approval processes. This isn’t the case with home equity loans, which lenders often have detailed processes for. 
• Closing costs may apply: Because you’re borrowing against your home, a home equity loan is considered a second mortgage. While the closing process isn’t as expensive or detailed as it is with a first mortgage, closing costs and other fees could apply. 

How to know whether a home equity loan is a good idea

As with any other type of financing, home equity loans have advantages and disadvantages. Here are scenarios in which a home equity loan could be a good idea and several instances where borrowing one might not make sense. 

It could be a good idea if…	It may not be a good idea if…
You have significant equity	Home values are declining
You’re seeking a large loan	You don’t have enough equity
You have excellent credit	Your credit needs improvement

You have significant equity

As we mentioned, many homeowners have significant home equity due to the hot real estate market. A home equity loan could be a decent choice if you’re one of these homeowners. Borrowing against your home could help you finance a home improvement project, pay for an unexpected medical bill or another large expense, and more. 

You’re seeking a large loan

A home equity loan might also be a smart choice if you’re seeking a large loan, and alternatives such as credit cards or personal loans aren’t enough. Depending on the lender, you could borrow up to 80% or 85% of your home’s value minus your outstanding mortgage balance.

You have excellent credit

A home equity loan might also be a good choice if you have excellent credit and sufficient equity. Taking on additional debt will affect your credit, and it may be less of a harsh blow if your credit is already excellent. 

Home values are declining

Because your lender considers the appraised value of your home when you apply for a home equity loan, borrowing one could be risky if home values are declining. If you borrow a large sum and your home’s value declines significantly, it could leave you underwater. Being underwater means the balance of your mortgage and home equity loan exceeds your home’s market value. 

You don’t have enough equity

You’ll generally need at least 15% equity in your house to be eligible for a home equity loan. If you don’t have enough equity, you’d be better off with a personal loan or credit card for immediate, necessary costs. You could also wait until you pay down your mortgage enough and apply for a home equity loan in the future.  

Your credit needs improvement

Taking out a home equity loan—or any new debt—could harm your credit in several ways, so it isn’t the best choice if your credit needs improvement. Your loan will increase your total debt, decrease the age of your accounts, and result in a hard credit inquiry when you apply. 

Does our expert recommend using a home equity loan to pay off unsecured debt?

Eric Kirste

CFP®

If you can afford the payments and reducing their overall interest rate and cash flow into a single loan, I may advise that this is a good use of a home equity loan. If your financial situation is better after the consolidation, and you can abstain from putting yourself into more debt or a worse-off position, this can help significantly.

How to mitigate the risks of a home equity loan

While home equity loans aren’t without risks, certain actions can help you mitigate these risks before you borrow. Ensuring you are financially stable is one of the best ways to protect yourself. Financial stability ensures you can afford an additional monthly payment, and since your home could be on the line if you default, this stability is crucial for home equity loans. 

Besides being financially stable, ensuring you have sufficient home equity and borrowing only what you need will mitigate your risks too. Both could help protect you from being underwater in your home.   

Is a home equity loan worth it? 

A home equity loan could be worth it if you have sufficient equity, stable income, and decent credit. However, your local real estate market should also factor into your decision to borrow against your home. If the market is declining, waiting to take out a home equity loan or exploring alternative financing options makes sense. 

Alternative financing options could also make sense if you’re seeking a small loan or want a simple application process. In that case, a personal loan may be a better choice. Many lenders offer personal loans as large as $35,000 or $50,000, which often close within a matter of days. Because home equity loans are a type of second mortgage, the application and closing processes are more involved. 

Our expert’s advice on wealth-building

Eric Kirste

CFP®

When using a home equity loan to aid in building wealth, I recommend the following best practices. 1) Home improvements: If the home improvements add to your home’s value, this can allow for a higher selling price. Home equity loan and HELOC interest payments may be tax-deductible when using the proceeds to buy, build, or substantially improve the property securing the loan. 2) Pay off debt: When using a loan to consolidate higher-interest debt into a single loan with a lower interest rate, this may dramatically reduce your overall debt payments, improving your overall cash flow to pay down debt faster or use the excess cash to start an emergency fund or contribution to retirement investment accounts. 3) There are other uses for a home equity loan, such as starting a business, buying an investment property, and using it for college tuition or other cash shortfalls. However, the key items above will help you build wealth.

Alternatives to a home equity loan

While a home equity loan can be a useful financial tool, it’s important to consider all your options. Depending on your specific needs, one of the following alternatives might be a better fit:

Home equity line of credit (HELOC)

A HELOC is similar to a home equity loan in that it allows you to borrow against the equity in your home. However, unlike a home equity loan, which provides a lump sum with fixed payments and interest, a HELOC operates more like a credit card.

You get a credit line to draw from as needed, and you only pay interest on the amount you borrow. This flexibility can be advantageous if you need access to funds over time, such as for ongoing home renovations or unpredictable expenses.

Cash-out refinance

A cash-out refinance involves refinancing your mortgage for more than you owe and taking the difference in cash. 

This option can be beneficial if you can secure a lower interest rate than your current mortgage rate or if you want to consolidate your home equity loan into your mortgage. However, this increases your mortgage balance and could extend the term of your loan.

Personal loan

Personal loans are unsecured loans that don’t require putting up your home as collateral. Because they’re unsecured, personal loans typically have higher interest rates than home equity loans, but they offer faster approval processes and more flexibility. They’re ideal if you need fast funds or don’t want to risk your home.

Credit card

For smaller expenses, a credit card might be a viable alternative to a home equity loan. Some credit cards offer low or 0% introductory interest rates for balance transfers or new purchases. 

While this can be an attractive option for short-term borrowing, paying off the balance before the introductory period ends is crucial to avoid high interest rates.

Reverse mortgage

A reverse mortgage is an option for homeowners aged 62 or older who want to tap into their home equity without making monthly mortgage payments. 

With a reverse mortgage, the lender makes payments to the homeowner based on the equity in the home. This can provide a steady income stream during retirement but will reduce the equity in your home and could affect your estate planning.

401(k) loan

If you have a 401(k) retirement account, you might consider taking out a loan against it. A 401(k) loan allows you to borrow money from your retirement savings, often with a low interest rate. However, approach this option cautiously; you’re borrowing from your future and may face penalties or taxes if you fail to repay the loan on time.

FAQ

What should you not use a home equity loan for?

A home equity loan is a powerful financial tool but is best reserved for specific purposes. Avoid using it for speculative investments, such as stocks or cryptocurrencies. These high-risk ventures could lead to significant losses and endanger your home if the investments fail. We don’t recommend using home equity loans for luxury purchases such as vacations or new cars because these items can depreciate quickly and don’t provide long-term financial benefits.

Is it better to borrow from a bank or home equity company?

Choosing between a bank and a home equity company depends on your specific needs. Banks often offer competitive interest rates, especially if you already have a relationship with them, and provide the added comfort of established customer service channels. However, home equity companies might offer more flexibility regarding loan products and approval criteria, which can be beneficial if you have unique financial circumstances or less-than-perfect credit.

Fees and costs can also vary between the two, so it’s essential to compare these. Some home equity companies might charge higher fees, but this isn’t always true. To find the best deal, shop around and compare offers from banks and specialized home equity companies.

Does a home equity loan affect your credit?

Yes, a home equity loan can affect your credit in several ways. When you apply, the lender will perform a hard inquiry, which can lower your credit score by a few points. Taking on new debt increases your overall debt load, which can affect your credit utilization ratio, a significant factor in your credit score.

Your loan payment history will also influence your credit score. Making on-time payments can boost your credit, and missed payments can harm it. Finally, the loan balance and how much of it you have paid off can affect your credit, with a lower balance relative to the original loan amount being more favorable.

Why would you not get approved for a home equity loan?

Several factors could prevent you from being approved for a home equity loan. Insufficient home equity is a common reason; most lenders require you to retain at least 15% equity in your home after the loan. A low credit score can also be a barrier. Many lenders prefer a score of at least 620, with higher scores leading to better terms.

Other factors include a high debt-to-income ratio, which indicates you may struggle to repay the loan, and unstable income, which raises concerns about consistent payment ability. Issues with your home’s title, such as unresolved liens or lender-specific requirements, can also lead to denial. Understanding these factors can help you better prepare your application.