Pros and Cons of a Home Equity Loan

Although home equity gains have slowed, Americans are sitting on record-high level of home equity: $311,000 on average at the end of Q3 2024, according to research firm Core Logic. With all that equity, many are considering tapping into it with a home equity loan. After all, you can use the funds for anything you need. However, home equity loans are subject to higher interest rates, so payments can cost more. Plus, if you fail to make payments, you risk losing your home. Before you submit a home equity loan application, consider your personal finances to decide if it’s the best move for you.

Key Takeaways

• Home equity loans allow you to access cash at a cheaper rate than many alternatives.
• They are quick to obtain, which can be both good and bad for borrowers.
• With higher interest rates, home equity loans come with higher payments. 
• If you can’t afford to repay your home equity loan, you could lose your home.

What Is a Home Equity Loan?

A home equity loan is exactly what it sounds like: a loan that allows you to borrow against the equity that you have in your home. While loan products vary across lenders, most home equity loans pay out an agreed-upon lump sum, and you pay back that loan with fixed, equal monthly payments over a set period of time until the loan is paid off.

By using your equity as collateral, home equity loans allow you to access larger sums of cash at a much lower interest rate than other unsecured forms of debt, like credit cards and personal loans, as long as you have enough equity in your home.

Calculating Your Home’s Equity

You can calculate your home’s equity by taking the current value of your home and subtracting the balance of any loans that you have on it. Then, divide that figure by the current value of your home. Let’s say you have a home valued at $400,000 with a $200,000 mortgage balance and no other loans against the home: $400,000 – $200,000 = $200,000. Then, $200,000 divided by $400,000 (your home’s value) is 50%. Congrats, you have 50% equity in your hypothetical home!

Pros of a Home Equity Loan

Home equity loans have some definite benefits, including:

• A fixed interest rate with set monthly payments for a fixed period of time. Having stable payments can make it easier to budget for repayment.
• Lower interest rates than many other common forms of debt. For instance, home equity loan interest rates are usually lower than those for credit cards or personal loans.
• Easy to obtain large sums of money that you may not qualify for through other avenues. You might find it easier to get a home equity loan if you have significant equity in your home compared to other loan products.
• The potential for tax deductions. If you use the home equity loan funds for home improvements, you might be able to deduct the interest from your personal property taxes.

Cons of a Home Equity Loan

Home equity loans aren’t without their risks. Before you take out a loan, consider the following drawbacks:

• You might borrow more than you need. A lump sum payment means that you may take out more than you need, spending the excess money frivolously and eroding your home’s value in the process. 
• You might struggle with repayments in the future. If you have other debt payments, you might find it hard to meet all of your financial obligations.
• You risk your home if you fail to make payments. You might face foreclosure if the loan becomes due and you can’t pay it back.
• There’s the risk of negative equity. If your home value drops, you might find yourself underwater on the loan.

Interest Rates Rising

Interest rates were incredibly low for much of the last decade, but this era appears to have ended. The Federal Reserve (Fed) has increased interest rates multiple times over the last several years, so borrowing against your home’s equity results in larger payments that may be harder to accommodate if your income decreases.

Do All Home Equity Loans Have Fees?

No, not all home equity loans have fees. Some lenders charge different fees depending on the amount of the home equity loan, and some have zero fees for any home equity loan. As with any loan product, shop around to make sure that you’re getting the best deal.

What Are Alternatives to a Home Equity Loan?

Alternatives to a home equity loan depend on the amount needed and the purpose of the loan. The greatest alternative to a home equity loan is either an emergency fund or delaying an expense and budgeting to save for it in advance, but neither is always possible. For a small amount, a 0% annual percentage rate (APR) credit card is a great alternative, but make sure that you pay it off before the promotional interest period is up. For a larger amount, a cash-out refinance may be a better option.

Can You Get a Home Equity Loan Without a Mortgage?

Yes, you can get a home equity loan whether or not you have a mortgage. If your home is mortgage free, then you definitely have enough equity in your home for a home equity loan as long as you meet the other lending requirements.

What Are the Requirements To Be Approved for a Home Equity Loan?

Individual lending requirements will vary, but in general, you’ll need a minimum of 10% equity in your home, with most lenders requiring 15% to 20%. In addition to having sufficient equity, you’ll also need all of the normal things that come with applying for a loan: proof of income, decent credit, and a good debt-to-income (DTI) ratio. The credit score and DTI requirements for a home equity loan generally are slightly more lenient than for unsecured debt like a credit card, as the loan is backed by an asset.

The Bottom Line

Home equity loans have long been used as a way for borrowers to access large sums of cash for relatively low interest payments. As interest rates rise, home equity loans are still a cheaper option than other forms of debt, but they carry the risk of losing your home if you can’t keep up with payments. Make sure that what you’re taking out the home equity loan for is worth the risk.