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A home equity loan gives you access to cash by tapping into the existing equity in your home. Also sometimes called a second mortgage, a home equity loan has several benefits, along with a few disadvantages. Find out what a home equity loan is, alternatives to a home equity loan, how and why it's useful and when it may not be the best option for you.
What Is a Home Equity Loan?
A home equity loan uses the equity in your home—the difference between your home's current market value and what you owe on your mortgage—as collateral for the loan. Like a regular mortgage, the loan is disbursed in one lump sum that you pay back in equal monthly installments over a fixed term—usually five to 30 years—at a fixed interest rate.
Although amounts may vary from one lender to the next, most lenders let you borrow up to 75% to 85% of your home's current equity. The amount you qualify for and the interest rate you pay will typically depend on your credit score and payment history.
Home equity loans allow you to use the cash for a variety of reasons, including funding your education, paying off or consolidating credit card debt, starting a business or paying medical bills. But if you use the money to buy, build or substantially improve your home, you may be able to deduct interest paid on the loan on your taxes. You can deduct interest on up to $750,000 of qualified home loans, or $375,000 for a married taxpayer filing a separate return, according to the IRS.
One caveat, though: These limits are for the sum of your regular mortgage plus your home equity loan, so if the total amount borrowed exceeds $750,000 (or $375,000 if you're married and file separately), you won't be able to deduct all the interest you paid.
Pros of a Home Equity Loan
Besides the flexibility in ways to use your loan and the possible tax break on interest paid, a home equity loan can provide many other benefits.
Fixed Interest Rates
Unlike variable interest rates that can rise and fall, fixed interest rates are unchanging throughout the term of the loan. Interest increases the total cost of your loan, so holding interest rates steady may lower the cost of the loan long term. Fixed rates, however, can also be a con, as discussed below.
Predictable Payments
Predictability of payment amounts can be a big plus. With a home equity loan, your payment is fixed for the entire term of the loan and does not change even if interest rates shift. You know exactly what you'll pay each month, making it easier to stick to a budget and predict your costs long term.
Lower Interest Rates
The potential risk to lenders is lower with a home equity loan than other types of loans because these loans are secured, meaning your house is used as collateral. For that reason, you may qualify for a lower interest rate than on some other financial products, like personal loans and credit cards. Of course, the rate you receive will likely depend on your creditworthiness.
Possible Interest Deduction
If you use your home equity loan to build, buy or make substantial improvements to your qualified residence, you may be able to deduct interest you pay on the loan on your annual tax return. This is a big advantage, especially if you take that savings and put it back into your home.
Cons of a Home Equity Loan
Along with the benefits, home equity loans also come with some fundamental drawbacks.
Fixed Interest Rates
Fixed interest rates can be a benefit, as your monthly payment doesn't typically change from month to month. However, if interest rates go down, you'll pay the same higher interest rate for the entire term of the loan. This means you'll be unable to take advantage of any savings that would come with lower interest rates.
Credit Score Requirements
While lenders look at employment, income, debt-to-income ratio (DTI), credit history and more when offering a home equity loan, your credit score is equally or even more important in your ability to get approved. Most lenders look for a good credit score in the range of 660 to 700 when approving loans, and the lower your credit score, the higher your interest rate is likely to be. A credit score of 700 or above gives you the greatest chance of qualifying and paying a lower interest rate.
Risk of Losing Your Home
Your home is used as collateral for a home equity loan. For that reason, defaulting on your loan or missing payments could cause you to lose your home to foreclosure. This is probably the biggest downside to taking out a home equity loan, so making sure you can make the payments before signing the loan documents is essential.
Closing Costs and Fees
Closing costs on your home equity loan can range from 2% to 5% of the loan amount, or between $2,000 and $5,000 on a $100,000 loan, for example. Fees might include an origination fee, appraisal fee, title search fee, credit report fee, loan recording fee and more. Loan requirements vary, however, and some lenders may charge no closing costs or fees at all. Shopping around or choosing a different loan product may help eliminate these extra costs.
Alternatives to a Home Equity Loan
If you've built up equity in your home, a home equity loan is one way to finance a major purchase, home improvements or another big expense. But it is not your only option.
Home Equity Line of Credit
A home equity line of credit (HELOC) is also secured by the equity in your home. It offers more flexibility than a home equity loan because you can borrow your full credit limit or draw smaller amounts when needed. And, you only pay interest on the amount you actually take out, much like a credit card. Depending on your credit score, DTI ratio and other factors, you can typically borrow between 60% and 85% of the equity in your home.
Generally, the draw period on a HELOC is 10 years. During this time, you can draw as much as you need up to your credit line. Depending on the terms of your loan, you might only pay interest on the amount you borrow during this time.
When the draw period ends, your ability to withdraw funds closes and you'll be required to repay the balance of your loan (or you can refinance to a new loan). Keep in mind that, if you don't pay back your HELOC, you could lose your home. Plus, most HELOCs come with a variable interest rate, which may make your monthly payment more difficult to budget for.
Besides having substantial equity in your home, you'll need a credit score of at least 680 for a HELOC, but some lenders may require a score of 720 or more.
Personal Loan
Personal loans can be secured or unsecured. If you qualify for an unsecured personal loan, your credit will still be damaged if you don't make payments, but you won't risk losing your house.
Personal loans are flexible and can be used for almost anything. They come with repayment terms that can range from only a few months up to seven years or longer. Interest rates are usually fixed, although some personal loans offer variable rates as well. Rates and repayment terms vary and can depend on your credit score, DTI ratio, employment and income, credit history and more. Most lenders prefer a credit score that falls in the range of 670 to 739 or higher, but you may be able to get a loan with a lower credit score.
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Cash-Out Refinance
Much like a home equity loan, a cash-out refinance lets you tap into the equity in your home if you want to borrow money.
A cash-out refinance replaces your existing mortgage with a larger new one, allowing you to pocket the difference in cash. So, instead of having two loans, like with a home equity loan, you'll only have one, possibly with a lower interest rate and monthly payment. Plus, your lender may let you borrow up to 80% of your home's equity.
Because your home is collateral for the loan, you may be able to get a cash-out refinance even if you have fair to poor credit, although a higher credit score may improve your odds. You'll also likely pay between 2% to 6% in closing costs on your new loan.
The Bottom Line
Home equity loans can be a good option for homeowners who need access to cash and have sufficient equity in their home. With fixed interest rates and predictable payments, plus the possible interest deduction, a home equity loan can be an excellent alternative to other forms of financing. But, there are drawbacks to consider. First and foremost, you're using your home as collateral, so what is likely your biggest asset is at risk.
Most lenders also prefer a higher credit score to qualify for a home equity loan. If you're not quite there, work on improving your score before you apply. You can check your credit score and credit history for free at any time with Experian.