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Home equity loans can be a good way to cover renovations, repairs, or sudden and unexpected expenses. They’re not right for every scenario, though. In some cases, they could be risky (or even cost you more in the long run).
Are you considering a home equity loan? This guide can help you make the right choice for your household.
In this article:
- How home equity loans work
- When using a home equity loan is a good idea
- How to take out a home equity loan
- When using a home equity loan is a bad idea
- Alternatives to home equity loans
- Is a home equity loan worth it?
How home equity loans work
Home equity loans let you borrow from your home’s equity. Here’s an example: say your home is worth $300,000, and your mortgage balance is $200,000. That means you have $100,000 in equity.
With a home equity loan, you could tap a portion of that $100,000 and use it however you like — to replace your roof, remodel your kitchen, or cover large medical bills.
Home equity loans function very much like mortgages. You’ll get your money up-front as a lump-sum payment and then repay it monthly (plus interest) for the duration of your term.
When using a home equity loan is a good idea
You’ll need to have a good amount of equity in your property to get a home equity loan. Most lenders require you to keep at least a 20% stake, so you’ll need more than that. You will also need solid credit — usually a score of 620 or higher.
If you qualify, you might consider taking out a home equity loan if:
- You need to improve or repair your house. Using the funds for improvements or repair of your house is one of the best reasons to use a home equity loan because that typically means increasing your home’s value. In some cases, it might also qualify you for a valuable tax deduction.
- You have several high-interest debts. If you’re dealing with costly credit card debt or personal loans, you may want to use a home equity loan to pay those off. Home equity loans and other mortgage products typically have lower interest rates than credit cards, personal loans, and even car loans, so they could save you significantly on long-term interest costs. They also streamline repayment (i.e., you’ll only have one monthly payment to make instead of several).
- You have sudden or unexpected expenses. If you don’t have the savings to cover large medical bills or other sudden expenses, a home equity loan could be a smart choice, particularly when compared to other options, such as high-interest credit cards or payday loans.
Keep in mind that home equity loans come with a monthly payment in addition to your existing mortgage payment. Make sure you’re prepared to handle both monthly payments before you apply for a home equity loan.
How to take out a home equity loan
You can get a home equity loan from online lenders and banks. Just like with your first mortgage, you’ll need to fill out an application, submit financial documentation, and pay closing costs. Additionally, the lender will often order an appraisal, which they’ll use to gauge your home’s value and how much equity you can borrow.
To get started, check out our recommendations for the best home equity loans, and make sure to get quotes from at least a few different lenders. This will ensure you get the best possible rate and terms.
You should also work on improving your credit score before applying. The higher your score, the lower your interest rate will typically be — meaning a smaller monthly payment and fewer long-term interest costs.
When using a home equity loan is a bad idea
Home equity loans aren’t a good idea if you haven’t built much equity in your home or your credit score is particularly low. You might not be eligible or the loan may come with a high interest rate, making it expensive in the long run.
You also shouldn’t use a home equity loan if:
- You need more cash flow. Home equity loans come with monthly payments, so this will only make the problem worse. If you’re unable to make your payments, some state law allows lenders to foreclose on your home if you have missed just one mortgage payment. Foreclosure could mean losing your home.
- You want to make a large, unnecessary purchase. Using a home equity loan for a vacation or a shopping spree isn’t a smart move. Borrowing to purchase nice-to-haves will only lead to more financial difficulties down the line.
- Your income is unpredictable. If your earnings are hit or miss, it could be hard to reliably make your payments. This could put your home at risk of foreclosure.
- You want to use it as an emergency fund. Every household should have an emergency fund in a savings account to deal with short-term financial events such as when a car or appliance dies or unexpected medical bills. If you don’t have an emergency fund, then you may have to resort to taking out a home equity loan, but at the same time you should plan to build your emergency savings account to prevent the need of financing in the future.
Alternatives to home equity loans
Home equity loans aren’t your only option if you need cash. You might also consider a cash-out refinance or a home equity line of credit (HELOC) if you want to use your home as collateral.
|Home equity loan||HELOC||Cash-out refinance|
|Payment||Set monthly payment (in addition to your existing mortgage)||Fluctuating monthly payments (based on how much you spend)||Set monthly payment (replaces your existing mortgage payment)|
|Funding||Lump-sum payment||Line of credit you can pull from (like a credit card)||Lump-sum payment|
Credit cards and personal loans are other popular options, but these tend to come with much higher interest rates. Some lesser-known options include a 401(k) loan, a loan from a friend or family member, borrowing from or selling an insurance policy, and a securities-backed loan.
>> Read More: Cash-out refinance vs. home equity loan
Is a home equity loan worth it?
Home equity loans might be a good move in some cases, but they’re not right for every household or every scenario.
If you’re not sure whether a home equity loan or any of the other options listed above are right for your goals, talk to a financial advisor to see what other options you have. They can point you toward the best move for your family.
>> Read More: What does Dave Ramsey think about home equity loans?
Author: Aly Yale