According to the latest CoreLogic Homeowner Equity Report, soaring home prices over the past year boosted home equity wealth to new highs through the fourth quarter of 2021. The amount of equity in mortgaged real estate increased by more than $3.2 trillion in Q4 2021, an annual increase of 29.3%. The average yearly gain in equity was $55,300 per borrower, more than two times the gain from a year earlier.
You may be one of those homeowners looking to tap into your home’s equity. It can be a good idea but it does come with risks.
When is a Home Equity Loan a Good Idea?
Your reasons for a home equity loan, also called a second mortgage, should always be a fiscally sound one or one that leaves you with no other option but to take out a loan.
You Need to Make Home Improvements
Getting a home equity loan is a good idea when you need money to fund a project that will directly increase the value of your home.
Home repairs, renovations, upgrades, remodeling, etc. When a HELOC is used to make home improvements, the interest you pay usually qualifies as a tax-deductible expense. The loan can also be tax deductible. Be sure to consult a tax advisor for your specific situation.
You Need to Consolidate Other Debts
Consider debt consolidation when you’ve finished your project ahead of schedule and have some money left over. Use the remaining money to consolidate any high-interest debt to save you money. Consider the difference between credit card interest rates and your home equity loan to see if consolidation makes financial sense. Remember that you need the discipline not to run up more credit card debt.
Not everyone is comfortable leveraging their homes. If you plan to take out a home equity loan only to pay off unsecured debt such as credit card debt, student debt, and personal loans, understand that leveraging your home as collateral is a calculated risk. If you cannot make the payments, you could lose your home.
You Want to Buy a Second Home
You can borrow money from yourself when you want to purchase a second home or investment property. Investing in a second home can be an excellent way to diversify your investment portfolio if you have enough equity in your home for a 20% downpayment on a new property.
Remember that the maximum loan-to-value (LTV) on a home equity loan is about 80-85%. If you fall below the 20% equity in your home, you will be subject to private mortgage insurance on top of your original loan. It’s best not to incur any unnecessary fees like this.
You Want to Avoid Student Loans
A home equity loan can be an excellent way to pay for higher education with a reasonably low-interest rate. With a home equity loan paying for college, you would have a fixed rate and know your actual monthly payments. You can also choose terms from 5 up to 15 years. Just be aware with a longer loan term, you will have lower monthly payments, but it will cost you more over the life of the loan.
When is a Home Equity Loan a Bad Idea?
A home equity loan isn’t always your best option. Here are some poor reasons to use a home equity loan:
You Need to Pay for Discretionary Expenses
You should not use a home equity loan for discretionary expenses like weddings, elaborate vacations, or luxury cars. Please do not use it to fund lifestyle choices your income can’t sustain.
Discretionary expenses can include costs associated with some home improvements. For example, using a home equity loan to put in a swimming pool is a terrible idea if you cannot afford the day-to-day maintenance expenses. Also, be aware that a swimming pool only adds about 7%-8% value to the home in most cases.
You Can’t Afford a Second Mortgage Payment
Suppose you can’t maintain two monthly mortgage payments. Adding a second mortgage also means additional payment. If your budget can’t support that, you’re better off with a different option, like a cash-out refinance.
You’re Thinking About Selling Your House
The costs associated with the loan may not be worth it. Think about the hefty closing costs; loan origination fees, appraisal fees, credit check fees, title and escrow, processing and underwriting, county recording, and flood certification. And in some cases, attorney fees. Ask yourself if you will recoup the money from the closing costs by the time you leave your home.
Closing costs for home equity loans and home equity lines of credit (HELOCs) are usually lower than closing costs for primary mortgages, but can still be relatively substantial.
When You Don’t Know How Much You Need to Borrow
If you’re uncertain or need flexibility, a personal loan will be a better option, particularly when mortgage interest rates are high. Unlike a home equity line of credit (HELOC), a home equity loan is paid out as a lump sum.
A HELOC could be a better option if you don’t know exactly how much you need to borrow. But be aware with a HELOC’s fluctuating interest rate and the current climate of soaring interest rates, you may not have the liquidity to bridge the gap as payments fluctuate, and it could land you in a deeper hole. On the flip side, you don’t have to take out the lump sum and can do your project a little at a time to get a handle on the monthly payments before withdrawing more funds from the account.
If Interest Rates are Fluctuating
HELOCs generally have adjustable rates, so when interest rates rise, your payments also rise.
Interest rates are significantly higher now than earlier this year, so HELOC borrowers are ending up with higher payments, which can lead to financial hardship.
READ MORE: 10 ways to use your home’s equity
What are the Key Risks of Home Equity Loans
- Your home is on the line: The stakes can be high. Be sure to talk to a financial advisor to ensure that this is the best method for your financial needs. You don’t want to increase your risk of foreclosure. For this reason, these are not a good option for situations like job loss.
- Equity fluctuates: This is an essential lesson from the Great Recession of 2008-2009. According to a 2011 report from CoreLogic, Borrowers who used home equity loans were more likely to be underwater (owe more than their homes are worth) during the recession. That makes it extremely difficult to relocate for a new job or move to a less expensive property if you need to sell your home. Housing prices can also fall.
- Your credit score can drop: Because your debt-to-income ratio will be higher due to an additional loan, your credit score will likely fall. The drop shouldn’t make much difference if you have solid credit. But if your score is in the acceptable range, even a slight decrease can significantly impact you.
READ MORE: Why did my credit score drop?
How Do Home Equity Loans Work?
The amount of equity you have in your home will determine the total you can borrow. You will repay it in monthly installments. You may have to pay appraisal fees to determine the loan-to-value ratio. Most loans will let you borrow up to 80% of your equity minus what you still owe on your first mortgage.
Which is Better: A Home Equity Loan or a Home Equity Line of Credit (HELOC)?
Both involve the same risks. A HELOC is a credit line with a variable interest rate, but a home equity loan usually has a fixed interest rate. When interest rates are up, it’s better to use a home equity loan than to carry a big balance on a HELOC. A HELOC offers more flexibility, though, particularly for real estate investors. And you’ll have a draw period, so you don’t have to decide how to spend the money immediately. Draw periods can last up to ten years.
Check out this video to learn more about the differences:
Should You Take Out a Home Equity Loan to Get a Tax Deduction?
No. Many Americans use the standard deduction and won’t benefit. The tax deduction will only make a difference if you already itemize your taxes.
According to the IRS, mortgage interest on a home equity loan is tax-deductible as long as the borrower uses the money to buy, build or improve a home. Homeowners can take the interest deduction on up to $750,000 in equity loans or up to $1 million for loans taken before 2018.
However, any home equity funds used for purposes other than your home aren’t tax deductible. The good news is you can take the deduction on a first or second home, just not investment homes.
How Can Home Equity Loan Proceeds be Spent?
There are no restrictions on how you can spend the loan proceeds, but it’s best to use caution, common sense, and fiscal responsibility. If you blow it all gambling in Vegas, invest it all in cryptocurrency or pay for a six-figure wedding, you’re risking foreclosure for temporary pleasure.
What are Some Other Types of Loans to Consider?
- Personal loan: Most loans are unsecured, making them less risky, but you may have to pay a higher interest rate.
- Credit card: Some cards offer an introductory offer of a 0% annual percentage rate (APR). If you can pay the card off before the end of the initial period, you’ll save quite a bit of money — and if you can’t, you can still consider a home equity loan when the transfer period is about to expire.
The Bottom Line
While it can be tempting to tap into some extra cash in your home, you will want to ask yourself why you need the loan, where to get the loan, understand your credit history to get the best rate, the total of all fees, and what your repayment plan is.
Taking a loan is a significant financial step. Ensure you understand all the loan terms well before getting the loan. Also, have a good plan for the money, and have a realistic repayment plan to avoid unnecessary costs or, worse, losing your home.
Maybe. It depends on a few factors. If you have a good credit score and qualify for the best personal loan interest rates, it may be better to go with the personal loan because the repayment terms are more flexible, and you aren’t using your home as collateral. You also won’t have to pay appraisal fees or loan closing costs.
However, suppose you have less-than-perfect credit and only qualify for personal loans with the highest interest rates. In that case, a home equity loan may allow you to borrow the money you need at a lower, fixed interest rate. Since your home backs the loan, the minimum credit score requirements are slightly more flexible.
It depends. If you have an adjustable-rate mortgage and want to refinance it to a fixed rate, you may be better off with the refinance. It’s also worthwhile if you’re refinancing to a mortgage with a lower interest rate, but finding one in the current market will be difficult. A cash-out refinance is applying for a completely new mortgage loan and using that to pay off the balance of your first mortgage. You will have to pay up to $5,000 in closing costs and origination fees and fund your escrow account, but the lender will roll everything into one monthly payment. The longer loan term may reduce your monthly payment, but you’ll pay more over the life of the loan.
No. You can choose any lender and should search for one who offers the lowest interest rate and best terms.
How to find a lender:
Decide if you want a face-to-face lender or an online one.
Read customer and company reviews for customer service
Consider mortgage brokers, traditional banks and online lenders
Research the type of loan you want and compare rates
Check their credit requirements if you have less than stellar credit
Confirm their geographic availability since not all lenders operate in 50 states
Ask for recommendations from friends and family