Remodeling the kitchen.
Building an addition for workspace.
Paying off debt.
There are a variety of good reasons to consider tapping your home for cash.
And in a hot market where home values skyrocket, taking out a home equity loan can seem like an even more attractive option.
In some ways, home equity loans are more advantageous to borrowers than other forms of financing, such as credit cards or a personal loan. Yet, using your humble abode as a source of money is not without risks.
Before you sign anywhere for financing, be sure to consider these pros and cons of home equity loans.
What are home equity loans?
As a homeowner, you have the option of using the equity in their home to borrow funds when needed. The equity in your home is the difference between the appraised fair market value of your home and the amount owed on the mortgage.
Banks typically let you borrow up to 75-80% of the equity in your home.
There are two types of home equity loans. Let’s break them down:
Home equity loan
Home equity loans are essentially second mortgages that are taken as a lump-sum payment and repaid monthly with interest over a certain period of time.
The interest rate on a home equity loan is fixed and generally lower than other consumer loans, but higher than mortgage interest rates.
The repayment period is much shorter than your typical 30-year mortgage; usually, from 5 to 15 years. You cannot borrow more money until the loan is repaid in full. As with both a home equity loan and a line of credit, the principal must be repaid once the property is sold.
Home equity line of credit (HELOC)
Home equity lines of credit are revolving credit lines like credit cards. They allow you to borrow up to a certain amount for the life of the loan. Your lender will determine the length of time you can withdraw money, typically 5-10 years, and when it needs to be paid back, which may range from 10 to 15 years.
You can withdraw money as needed during the withdrawal period, and as principal is repaid, more credit up to the credit limit becomes available again. The interest rate is variable, so it changes every time the Federal Reserve raises or lowers rates.
Minimum monthly interest payments fluctuate depending on current interest rates and the balance owed. Payments are flexible since homeowners can choose to pay the interest only or a combination of interest and principal, which stretches payments out over many years, resulting in smaller monthly payments.
Advantages of Home Equity Loans
First, the upside of home equity loans.
Lower interest rates
The first advantage of home equity loans is that they generally carry a lower interest rate than other consumer loans. Remember, the average credit card rate is around 16-18%, compared to the average home equity loan rate in the single digits.
That’s because home equity loans and lines of credit are secured loans, which lenders consider less risky. Therefore, lenders are willing to charge lower interest rates for them.
Potential tax-deductible interest payments
The second advantage of home equity loans or lines of credit is that the interest charges are generally tax-deductible if the loan is used to acquire, build or make capital improvements to your primary residence and one other home, such as a vacation home.
The interest on the loan is not tax-deductible if it is used for personal expenses other than capital improvements, such as to pay off credit card debt, pay for tuition or finance a vacation.
Keep in mind, your loan’s origination date comes into play here.
Prior to the enactment of the Tax Cuts and Jobs Act in 2017, the interest was tax-deductible up to a maximum of $1 million if the loan was used to buy, build or make capital improvements and up to $100,000 if the loan was used for personal expenses. Today, for any loan that originates on or after December 15, 2017, interest charges on home equity loans or lines of credit are tax-deductible up to a maximum of $750,000. Amounts above this are prorated.
Disadvantages of Home Equity Loans
Now, the downsides, which are most likely to occur if you run into financial trouble.
Your home is at risk
A major disadvantage of a home equity loan or a home equity line of credit is that it puts your home at risk. In other words, you could lose your house.
Homeowners pledge their home as collateral for the loan, which means the lender can repossess the home and sell it to satisfy the outstanding debt on the loan.
Many homeowners take out home equity lines of credit to consolidate their credit card debts to make them tax-deductible and pay them back at lower interest rates. However, you are unable to make payments, credit card debt can be discharged under Chapter 7 bankruptcy laws while home equity loans are secured and must be paid back in full.
You may owe more than the home is worth
Another disadvantage is when a home equity loan has been taken out and the value of the home drops significantly in price. In this case, you may owe more than the house is worth.
If your house needs to be sold to satisfy creditors, this could cause a significant problem. Also, you might be unable to lease your home during the term of the loan to generate extra income, if needed, to pay your debts.
Limits other financing options and impacts your cash flow
A third disadvantage is that the use of a home equity loan also limits future financing flexibility. Although it can be an excellent source to use for emergencies, you can have only one home equity loan outstanding at a time. And don't forget that any borrowing places an obligation on your future cash flow and reduces your future disposable income.
Ultimately, you should always use caution when taking out any type of loan. Make sure you aren't taking on more debt than you can support. Therefore, when considering different financing options for your financial goals work with a financial adviser to build a financial plan that will help determine the most appropriate choice for you.
From managing your 401(k) to choosing the right age to claim Social Security, there are many more important financial steps that will help you achieve your financial goals. You can find them in our free ebook, Your Money in Your 50s: A Retirement Planning Guide for Procrastinators and Avid-Savers.