Advantages and Disadvantages of a home equity loan

What is a home equity loan?

When home values rise, homeowners often consider tapping their home equity. The average homeowner can borrow about $178,000 using their home as collateral, according to mortgage data firm Black Knight.

A home equity loan is one way to access those funds. A type of borrowing that acts as a second mortgage, a home equity loan provides funds as a lump sum and then the loan is repaid with a fixed interest rate over time. Because the loan is secured by your home, interest rates are typically lower compared to some other forms of borrowing that are not secured by an asset. But it’s a good idea to learn the advantages and disadvantages before using a home equity loan.

How does a home equity loan work?

A home equity loan allows you to borrow money using the equity you’ve accumulated in your home as collateral. Equity is the difference between your home’s current value and the balance owed on your mortgage. For example, if your home is currently valued at $400,000 and you owe $200,000 on your mortgage, you have $200,000 in equity.

When you take out a home equity loan, you’ll receive all of the funds upfront, usually with a fixed interest rate. These loans often come with closing fees, but you might be able to roll them into the principal balance of the loan. You’ll make fixed monthly installment payments over time, typically over the course of five to 30 years.

Home equity loan requirements

As with any loan, qualifying is based on a combination of factors including your credit score, income history and debt-to-income ratio. But with a home equity loan, lenders also check your loan-to-value ratio, which is the percentage of your home current value that’s still financed by a mortgage.

Advantages of a home equity loan

Home equity loans come with a lot of perks, including:

Fixed interest rate. The interest rate on a home equity loan is often fixed, meaning it will remain the same for the life of the loan and will not go up or down — even if rates fluctuate in the market. That makes your payments predictable over the life of the loan.
Fixed payments. Because your interest rate is fixed and you receive all of the funds upfront, the monthly installments will also be fixed for the life of the loan. This makes it easier to budget for your monthly expenses.
Relatively low interest rate. Because your property secures the home equity loan, interest rates are typically lower compared to unsecured forms of borrowing, such as personal loans and credit cards.
Long repayment terms. You may be able to choose a loan term as long as 30 years, which can help make your payments more affordable. However, longer loan terms mean you’ll pay more interest over time.
You can use the money for any purpose. There are no restrictions on how you can use your home equity funds.
Potential tax breaks. If you use home equity loan funds to substantially improve the home that secures the loan, the interest may be tax-deductible.

Disadvantages of a home equity loan

Like any financial product, home equity loans also come with drawbacks. Some of these include:

Risk for your property. Your property acts as collateral on the home equity loan, which means the lender can foreclose on your home if you fall behind on your loan payments.
The potential to owe more than your home is worth: When you take out a home equity loan, the equity is based on the home’s current value. But if home values drop in the market, the value of your home could go down, too. That creates a risk that you’ll become “underwater,” where you owe more than your property is worth.
Requirements to qualify: Lenders usually require you to have at least fair credit to qualify for a home equity loan, though the most competitive rates usually go to borrowers with good to excellent credit. You’ll also need to retain around 10% to 20% equity in your property after taking out the home equity loan.
Closing costs. Lenders typically charge closing costs that can range from 2% to 5% of the loan amount. However, you may be able to roll these into the loan.
Two mortgage payments. If you still have a first mortgage when you take out the home equity loan, you’ll have to manage two payments each month. That can strain your monthly budget.
Loan limits. Lenders usually set a minimum amount you can borrow, which may pose problems if you just need a few thousand dollars or less. If you need to make a small purchase, a credit card may be the better way to go.

If you’re uncomfortable with the downsides, you might consider holding off on your home equity loan.

How to apply for a home equity loan

Here are the steps you can take to borrow from your home equity:

Figure out how much you can borrow. The maximum you can borrow is based on your home’s current value, the balance on your mortgage and the combined LTV ratio set by your lender. Based on how much you can borrow, determine how much you need.
Check your credit. Lenders generally want you to at least have fair credit, but you may qualify for better interest rates if you have good to excellent credit. If your credit needs work, consider taking steps to improve your credit score.
Get quotes and compare interest rates. Each lender sets its own qualification requirements, loan limits, interest rates and loan terms, so it’s a good idea to shop around and investigate different lenders. “You don’t have to get your loan or line of credit with your current mortgage provider,” Kassi Fetters, a certified financial planner says. Get quotes from at least three lenders and compare the details.
Complete your application. Once you choose a lender, complete the application and submit the required supporting documents. Fetters says you’ll need to provide proof of income and proof of homeowners insurance, so gather copies of your insurance policy, bank statements, pay stubs and employer information ahead of time.
Close on the loan and receive funds. After your lender reviews your application and supporting documents and orders a home appraisal, they’ll give you their decision. If you qualify for the home equity loan, you’ll receive the funds and can use them as you wish.