Home Equity Loan Pros and Cons
A home equity loan offers several advantages and disadvantages when compared to other financing options for taking cash out of your home such as a home equity line of credit (HELOC) or cash-out refinance. Home equity loan positives include saving time and money as compared to a refinance, lower interest expense over the life of the loan, the ability to access the specific amount of proceeds you need and the certainty of a fixed rate. Considerations include a higher interest rate compared to a mortgage or HELOC, the inability to draw down on the loan multiple times and potentially extra fees.
We review the full list of the pros and cons for a home equity loan below. Borrowers should understand both the positives and negatives of a home equity loan to determine if it is the right financing option for taking cash out of their homes.
Home Equity Loan Pros
Save Time and Money as Compared to a Cash-Out Refinance
A home equity loan saves you time and money as compared to other methods for accessing the equity in your home such as a cash-out refinance. Closing costs for a home equity loan are usually lower than for a refinance because the loan amount is smaller. Additionally, the loan application and closing processes are streamlined as compared to a full refinance.
Fixed Interest Rate Provides Certainty
The interest rate on a home equity loan is fixed as compared to the rate for a home equity line of credit (HELOC) or adjustable rate mortgage (ARM), which can change and possibly increase significantly over the course of the loan. Having a set interest rate means that your monthly loan payment remains the same for your entire loan term which can help you better manage your finances. The predictability of a home equity loan also provides greater peace of mind and removes the risk of payment shock if interest rates increase in the future.
Lower Total Interest Expense Over Life of Loan
The total interest expense borrowers pay over the life of a home equity loan is usually less than the total interest when you refinance your existing mortgage. This is because a home equity loan is usually smaller than a new mortgage when you refinance -- a smaller loan means you pay less interest expense. Additionally, the term for a home equity loan is usually five to twenty years, with fifteen years being the most common length. By comparison, 30 years is the most common term for a mortgage, although it is certainly possible to get a mortgage with a shorter term. Because home equity loans are smaller and shorter in duration, borrowers pay less interest over the term of the loan even though the interest rate on a home equity loan may be higher than the rate on a mortgage.
Access Only the Amount of Proceeds You Need
Borrowers using a home equity loan usually have a specific use of proceeds in mind and can target the loan size to meet their financial needs. While most lenders have a minimum loan size for home equity loans, home owners are usually able to borrow only the amount of money they need. The flexibility to access the specific amount of money you need with a home equity loan reduces your monthly loan payment, lowers total interest expense and prevents unnecessary borrowing.
Few Limits on Use of Proceeds
Although lenders want to understand the use of proceeds for a home equity loan, there are typically few limits on how borrowers spend the money. Borrowers can use the proceeds from the loan for any number of purposes including home renovations and repairs, college tuition, paying off high interest credit card debt or buying a second home. A home equity loan affords borrowers significant flexibility on how they use the equity in their home.
Higher Debt-to-Income Ratio Increases Borrowing Capacity
The maximum borrower debt-to-income ratio for a home equity loan is usually higher than for a mortgage which potentially increases your borrowing capacity. For example, the maximum debt-to-income ratio for a mortgage is usually 43% to 47% depending on several factors including your credit score and loan-to-value (LTV) ratio while the maximum debt-to-income ratio for a home equity loan is typically 55%. With a home equity loan, lenders permit a higher debt-to-income ratio which enables you to borrow more money. Lenders tend to focus more on how much equity you have in your home and the combined loan-to-value (CLTV) ratio of your first mortgage plus your home equity loan in determining what size loan you qualify for.
Home Equity Loan Interest is Tax Deductible in Most Cases
Interest expense on a home equity loan is tax deductible as long as the loan is used to buy, build or substantially improve the property that secures the loan. Additionally, home equity loan interest is tax deductible as long as the total amount of loans secured by the property does not exceed the value of the property and the total amount of the loans, including the first mortgage, does not exceed $750,000 (in most cases). For example, if you take out a home equity loan to remodel your home, then the interest expense on the loan is usually tax deductible.
Home Equity Loan Cons
Higher Interest Rate than First Mortgage or HELOC
The interest rate on a home equity loan is typically 1.0% to 2.5% higher than the current market interest rate for a first mortgage and also higher than the initial interest rate on a HELOC. The higher interest rate increases your monthly loan payment. Borrowers should shop lenders to find the home equity loan with the lowest interest rate and fees.
Fixed Loan Amount
With a home equity loan, your loan amount is fixed and you do not have the ability to take additional proceeds even if you pay down your principal loan balance over time. By comparison, with a home equity line of credit borrowers can pay down their loan balance and take additional proceeds by drawing down the line an unlimited number of times. Receiving all home equity loan proceeds upfront reduces your financial flexibility as compared to a HELOC.
Potential for Additional Fees
Some lenders charge extra fees and pre-payment penalties for home equity loans. Although borrowers are usually required to pay an appraisal report fee, other closing costs for the loan should be lower than for a refinance. Borrowers should be aware of any extra fees including pre-payment penalties before selecting a home equity loan lender.
More FREEandCLEAR Resources
How a Home Equity Loan Works
Review our comprehensive overview of how a home equity loan works including key loan terms, borrower qualification requirements, interest rates and combined loan-to-value (CLTV) ratio limits.
Home Equity Loan Rates
Home equity loans are provided by traditional lenders such as banks, mortgage banks and credit unions. Use our home equity loan rate tables to compare interest rates and fees for lenders in your area. Comparing rates from multiple lenders is the best way to save money on your home equity loan.
Best Ways to Take Cash Out of Your Home
Compare and contrast numerous ways to access the equity in your home including a home equity loan, home equity line of credit (HELOC), cash-out refinance and reverse mortgage. Understand the positive and negatives of each financing alternative to understand the option that is right for you.
Comparing a HELOC to a Home Equity Loan
Review our detailed comparison of a home equity loan to a HELOC including interest rate, monthly payment and reasons to select each financing option. Compare a home equity loan to a HELOC to determine the best financing option for you based on your personal and financial objectives.
Sources
“What is a home equity loan?” CFPB. Consumer Financial Protection Bureau, September 25 2017. Web.