The pros and cons of a home equity loan

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Owners who have bought a year or two ago may be considering their situation right now and feeling rather lucky: they bought before interest rates have skyrocketedand some sit on important home equity.

If you are in this camp, or if you bought before this real estate boom, and are looking to take advantage of this equity, a home equity loan could be a great option. It is a way of borrowing a lump sum of money — to finance a home renovation or one debt consolidation, for example — with a relatively low interest rate compared to other forms of debt. And unlike a cash refinancewhich was a popular option until recently, you won’t have to give up a low interest rate on your main mortgage.

But before deciding on a home equity loan, you should consider the potential disadvantages, too. Here’s what you need to know about the pros and cons.

What is a home equity loan?

A home equity loan is a second mortgage, which means it’s a loan on your home that takes a “second position” after your main mortgage. You can use the money for anything and you will receive the money in a lump sum once the loan is approved.

“You basically take equity, or what you have in your home, and borrow against it,” says Marguerite Chengcertified financial planner at Blue Ocean Global Wealth.

This is different from a home equity line of credit, which also relies on the equity in your home, but works more like a credit card, where you only pay back what you spend. Home equity loans, on the other hand, are more rigid: you withdraw a sum of money all at once and pay it back in fixed payments (with interest) over the term of the loan, usually 20 or 30 years.

Prices are on the rise

The highest inflation in 40 years has yet to come down. The consumer price index showed price up 8.2% year-over-year in September, barely an improvement from August’s 8.3%.

This has implications for the Federal Reserve’s efforts to curb price growth, but it also means a lot for consumers, especially those looking to borrow money. The Fed will likely continue to raise its benchmark interest rate – the federal funds rate – in its continued attempt to stem demand and reduce inflation. But that rate affects the cost of borrowing money across the economy, especially home equity lines of credit or HELOCs.

HELOCs often have variable interest rates that are directly tied to an index – the prime rate – that moves in parallel with the federal funds rate. When the Fed raises rates, it means HELOC borrowers are paying more.

Fixed-rate home equity loans aren’t as directly affected, but those rates are set based on the lender’s cost of funds, which also increases as rates rise.

The economic situation means that home equity rates are probably far from over rising, experts say. “I don’t expect [rates] increase at the same rate as over the past nine to twelve months. But I think they will go up. Kevin WilliamsCFP and founder of Full Life Financial Planning, tell us. “Hopefully they’ll slow down, but we’ve seen a lot of ups and downs so it looks like there’s still room for them.”

Benefits of Home Equity Loans

There are many reasons why borrowers love home equity loans: they’re one of the cheapest forms of debt available, they can give you a large sum of money up front, and their payments are predictable.

“A lot of people have untapped equity in a home,” says Charles Sachs, Certified Financial Planner at Kaufman Rossin Wealth, LLC in Miami. A home equity loan is a great way to take advantage of this; here are the main advantages:

Relatively low interest rates

Interest rates for just about every type of debt are going up right now. But generally speaking, loans secured by your home offer some of the lowest interest rates, especially compared to credit card Where personal loans.

Currently, interest rates for a home equity loan are as low as 5%, compared to 10% or sometimes even 20% on credit cards. Plus, when you take out a home equity loan, you lock in the rate, meaning it will stay the same for the life of the loan.

Predictable payments

You can think of payments on a home equity loan the same way you make your principal mortgage: The payment that is fixed at the very beginning is the payment that you will pay every month, for decades.

“With a home equity loan [the benefit] it’s that it’s a fixed payment,” says Cheng. “Not only is the interest rate fixed, but your payment is fixed.”

This predictable amount allows you to budgetand to ensure that you will be able to pay the payments for the full term of the loan.

Potential tax advantages

If you are looking for a home equity loan to finance home improvementthe interest you pay on the loan could be tax deductible.

“That’s a huge advantage, especially if you take the money from your house and put it back into your house,” Cheng says. She recommends speaking with a tax professional to understand what the tax implications are in your particular case. But it may reduce your tax bill at the end of the year.

Disadvantages of home equity loans

Like any form of debt, home equity loans also have drawbacks. Receiving a lump sum of cash all at once can be dangerous for the unruly, and interest rate – although low compared to other forms of debt – are higher than primary mortgages.

Exceedance potential

You might need a lump sum of money for a big project, but receiving tens of thousands of dollars at a time can be tempting. Cheng warns that if you’re not disciplined about using money for specific purposes, you could be in trouble.

Experts recommend against using the funds for day-to-day expenses or luxuries like a boat or fancy car – especially because if you default on the loan, your home is at risk.

More expensive than a primary mortgage

The simple fact of home equity loans is that they come after your main mortgage. This means that if you stop making payments, the home equity lender is in line with your main mortgage. To compensate for this, interest rates are slightly higher on home equity loans than on your original mortgage.

Longer and more expensive application process

Taking out a home equity loan isn’t as easy or as quick as applying for a new credit card. The process usually takes weeks or even months while the bank reviews your application and your credit history.

These loans may also involve fees or closing costs, which means there is a cost to accessing the equity in your home. Check with a lender to understand the fees you may incur.

Advantages

  • Lower interest rates than other forms of debt

  • Payments are the same throughout the life of the loan

  • Interest could be tax deductible if used for home improvements

The inconvenients

  • You could spend too much if you withdraw too much

  • Interest rates are higher than for a mortgage

  • The application process is longer and more expensive than for credit cards

Home Equity Loan Alternatives

Maybe a home equity loan just isn’t right for you. Consider some of the other options for tapping into your home equity and accessing funds:

HELOC

Home equity lines of credit are another popular option, and for good reason. They offer a level of flexibility that a home equity loan does not. HELOC works like a credit card: you can spend up to a certain limit during the draw period and you only refund the amount you have spent. But be aware that HELOCs often have variable interest rates, and these are only likely to increase in the near future; which makes your payment very unpredictable.

Refinancing by collection

A cash refinance is a way to recast your main mortgage to a higher amount and extract the difference – part of your home’s equity – in cash. This is another way to access lump sum financing. But it would also mean giving up your current mortgage interest rate, which is likely much lower than current rates.

That said, it’s important to crunch the numbers. Cheng advises comparing the “blended” rate on your primary mortgage and a home equity loan, and comparing it to the single interest rate on a cash refinance. “If you’re borrowing a lot of money, you might want to do a cash refinance,” Cheng says.

Pro tip

When deciding between a home equity loan and a cash refinance, compare the combined interest rate you would pay with your current mortgage and home equity loan with what you would get with a cash refinance.

Personal loan

Unlike home equity loans, a Personal loan is generally not secured by your home. That means it’s riskier for the banks (because they have nothing to fall back on) and interest rates are much higher as a result.

They could still be Worth to be consideredhowever, if you need a small amount of money and need it quickly – say, for a medical fees or one urgent home repair.

“It’s definitely a question of what do you need, how much do you need and what is the purpose?” Cheng said.

Cash

There is, of course, another way to finance your project: cold hard cash.

In a rising interest rate environment, it might make sense to forgo debt entirely and simply save money for this home renovation. Cheng suggests making a monthly contribution to your savings and earmarking a portion of any windfalls for that goal.

It’s also not a bad idea to save about 25% more than you think you need. “Nobody ever fired me for setting them aside too much,” Cheng says.

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