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Borrowing against your home equity is a big decision. The money could help you pay off high-interest debt, make home improvements or improve your life in some other way. But it also brings expenses and risks you should understand so you don’t regret getting a home equity loan in the future.
1. Not Getting Multiple Quotes
Filling out loan applications can be tedious. But if you only apply with one lender, you won’t be able to compare your offer with others, which limits your choices.
With home equity loans, you may find a better variety of offers than with conventional and government purchase and refinance loans. Lenders have more flexibility to set their own standards for home equity loans.
Lenders evaluate risk in different ways. You should evaluate several lenders before applying. One company might be comfortable lending to borrowers with high debt-to-income (DTI) ratios if they have excellent credit. Another lender may allow below-average credit and charge you a higher interest rate.
Getting multiple quotes will show you how good of a deal you can get. An extra hour of your time could save you thousands of dollars.
2. Thoughtless Spending
If you’re going to substantially reduce your home equity, increase your mortgage debt and pay interest and closing costs, create a plan for how you’ll use your home equity before taking out the loan.
Consider the impact of monthly payments on your budget. Evaluate the effect of loan expenses on your long-term financial status. Weigh those things against the benefits you expect from your planned use of the money.
Are you unsure if it makes sense to get a home equity loan? Consult a financial planner who will work with you for an hourly or project-based fee.
3. Expecting a Large Tax Deduction
You can deduct home equity loan interest when you use the money to substantially improve your home. However, the home mortgage interest deduction isn’t as valuable as it once was—especially for married couples.
The Tax Cuts and Jobs Act of 2017 doubled the standard deduction you can claim on your tax return. That means you need far more Schedule A deductions before seeing any savings from itemizing. In 2023, the standard deduction is $13,850 for single filers, $27,700 for married couples who file together and $20,800 for heads of household.
If you spend a lot on first mortgage interest, property taxes and charitable donations, you might save money on taxes by itemizing your home equity loan interest. But that savings may not offset the loan cost as much as you hope.
For example, if you borrowed $100,000 at 8% interest for 20 years, your total interest expense in the first year would be $5,815.91. If you were able to deduct all of it and your marginal tax rate was 24%, your savings would be $1,395.81.
4. Expecting a Return on Home Improvements
Home improvements are a common reason to tap your home equity since you’re reinvesting the money in your home to improve its value.
However, don’t assume your proposed project will increase your home’s value. Annual studies published by Remodeling Magazine consistently find that most home improvements have a negative return on investment.
There are other valid reasons for home improvements: to make your home more enjoyable or accessible, for example. It’s fine to spend your home equity loan on upgrades you can afford or genuinely need. Remember that your spending may not translate into a higher price when you sell.
Risks of Home Equity Loans
Borrowing against your home’s value always has risks. While the risks below are not unique to home equity loans, they’re still things you should consider before you borrow.
Possible Selling Challenges
Having a home equity loan doesn’t make it harder to sell your home, but having more debt secured by your property does. It means you need to net more money from the sale after paying real estate commissions and other costs, which raises the bar for the minimum offer you can accept.
If you later decide to move, local real estate market conditions might not favor finding a buyer at the price you need.
There’s always the risk that your financial situation could change and you won’t be able to repay your loan. Home equity lenders can foreclose if you default.
However, they might choose not to, especially if you have a first mortgage. Your home’s value would have to be enough for the home equity lender to recoup what you owe after the first lender is repaid from a forced sale of your home—and after accounting for all the associated fees.
Pros and Cons of Home Equity Loans
Like any financial product, home equity loans have benefits and drawbacks. Here are some important ones to consider before you borrow:
- Relatively low interest rates. Compared to other forms of borrowing, such as credit cards and personal loans, home equity loans have some of the lowest rates because your home secures them.
- Fixed interest rates. At the outset, you’ll know exactly how much each monthly payment will be and your total borrowing costs.
- Flexibility. You can use the money from a home equity loan for any purpose.
- Closing costs. You might pay 2% to 5% of the loan amount to cover origination and underwriting fees, a home appraisal, title services and other expenses.
- Monthly payments. Home equity loans usually have terms of 10 to 30 years, which can be a long time to have an extra monthly payment in your budget.
- Equity requirements. You won’t be eligible for a home equity loan if there isn’t enough difference between your home’s value and your existing mortgage debt.
4 Alternatives to Home Equity Loans
One way to tell whether a home equity loan is your best option is to compare it to the alternatives. Consider these four options to get money before getting a home equity loan:
1. Home Equity Line of Credit
A home equity line of credit (HELOC) gives you revolving access to a portion of your home’s equity. The interest rate is variable instead of fixed, with limits on how high or low it can go.
Many HELOCs allow you to make low, interest-only payments for several years before requiring you to repay the principal. Also, you may be able to lock in a fixed rate on the money you withdraw.
However, flexibility means less security for the borrower. If your credit score drops or market conditions get ugly, your lender could reduce or freeze your credit line.
2. Cash-Out Refinance
A cash-out refinance replaces your existing mortgage with a new, larger loan. When the loan closes, you get the difference—part of your equity—as cash.
A cash-out refi can be a good option if you’re looking to save money on your existing mortgage, lower your monthly payment or change loan types—and you also want to access your home’s equity.
Because of the large loan size compared to the other options presented here, closing costs can be particularly high. You’ll need to do a breakeven analysis, like you would with any refinance, to see how those costs compare to the loan’s financial benefits.
3. Personal Loan
Personal loans can help homeowners borrow money without risking their homes. The rates, fees and amounts vary among personal loan lenders depending on your income, credit score and existing debts. You could borrow as much with a personal loan as you could with a home loan.
You might even get a comparable interest rate. Or you could borrow far less and be offered an annual percentage rate (APR) as high as 35.99%.
The application process is simpler and the time to close is faster than a home equity loan because the lender doesn’t have to underwrite your property. And a personal loan is usually unsecured, making it harder to lose your home if you default.
However, your creditor could ask the court for a judgment that places a lien against your home. If you wanted to sell or refinance your home in the future, you’d have to use some of the proceeds to pay off the judgment.
4. Low-Interest Credit Card
Many credit cards offer an introductory period with a 0% APR for at least 12 months. Depending on how much money you need and how quickly you can pay it off, one of these deals could be simpler and more cost-effective than a home equity loan.
You won’t be able to get a low fixed rate for a long term with a credit card like you could with a home equity loan. Instead, you’ll get a variable rate based on your creditworthiness. But the debt will be unsecured and approval can happen instantly.
If you need cash, however, this option may be your worst. Cash advances start accruing interest immediately and usually aren’t eligible for a promotional rate.
Find the Best HELOC Rates of 2023