A home equity loan, or second mortgage, allows you to withdraw the equity you’ve built up in your home so you can use the cash to make repairs to your home, pay for college tuition, or consolidate your debt, for example.
You repay the money over time through a series of regular payments. Home equity loans have a number of benefits, but there are some downsides to consider as well. If you're not sure if a home equity loan is right for you, you can weigh the pros and cons of alternatives such as lines of credit, refinancing, or personal loans.
Key Takeaways
- Home equity loans use your home as collateral, which brings a risk that the lender could take your property.
- With a home equity loan, you will take on a second monthly payment, which can impact your budget.
- Alternative to using a home equity loan include a HELOC, a cash-out refinance, or a personal loan.
Downsides of Using a Home Equity Loan
While many homeowners appreciate the flexibility home equity loans offer, there are some drawbacks to this type of financing. Among the downsides is the fact that your home secures these loans. So if you can no longer afford to make the payments—for example, if you lose your job—you could lose your house.
In addition, this type of loan adds a payment to your budget each month. If your cash flow is tight and you're using the money for expenses other than consolidating your bills, a second mortgage might not be a good fit.
Having a home equity may also limit your ability to refinance your primary mortgage. So if you want to refinance for better terms on your original mortgage, you may want to delay taking on a home equity loan. Consult your lender or a financial advisor for guidance on your specific situation.
If you’re not sure if a home equity loan is right for you, consider the pros and cons of the following alternatives.
Home Equity Line of Credit (HELOC)
A home equity line of credit, or HELOC, is another type of second mortgage. It’s similar to a home equity loan because you’re accessing the equity built up in your home. But unlike with a regular loan, a HELOC works more like a credit card with a revolving line of credit.
You’re approved for a certain amount of money. You then can access those funds anytime you need them during the loan’s draw period. During this time, you only pay interest on the money you’ve used.
HELOCs usually have variable interest rates. So among the downsides of these loans, your payments won’t be the same each month, which means you won’t have predictable monthly payments.
Once the draw period is over, you’ll need to start repaying the principal, which means your payments will be larger. In some cases, a lender may require a balloon payment, or payment in full, although most HELOCs provide repayment periods of about 10 to 20 years.
If you can’t afford the higher payment, your bank may allow you to refinance your HELOC.
Cash-Out Refinance
A cash-out refinance is another option for tapping equity in your home. This type of loan is when you take out a new primary mortgage for more than the amount you currently owe. As with a home equity loan, you get this extra money in a lump sum of cash, and you can spend the funds any way you’d like.
With a cash-out refinance, you won’t add a second payment each month. You can get a cash-out refinance that doesn’t add to the amount of your monthly payments. However, you'll extend the length of the loan. Also, since a cash-out refinance is a primary mortgage, you’ll usually qualify for better interest rates.
Moreover, lenders may not require as high a credit score to approve you for a cash-out refinance compared to a home equity loan. So if you don’t have great credit, this could be a good alternative.
Keep in mind that anytime you refinance, you have to pay closing costs. If you don’t have a lot of money upfront, taking out a home equity loan might make more sense.
Reverse Mortgage
If you’re at least 62, you may be eligible for a reverse mortgage. This type of loan lets you use your home equity to supplement your income in retirement.
You’re not required to make any payments with a reverse mortgage as long as you live in the home. These terms can save you money right now. The loan is due when the last borrower dies or moves out of the house. At that point, you or your heirs can sell the home to pay off the loan. If the sale price isn't enough, you or your estate is responsible for making up the difference.
Reverse mortgages do have some drawbacks, such as high fees. You may need to pay for origination costs, mortgage insurance, and closing costs. Due to these limitations, a reverse mortgage may not make financial sense for everyone. Consider consulting a financial advisor about options for your situation.
Personal Loans
A personal loan is another home equity loan alternative. With this type of loan, you can borrow money and use it for any purpose. Unlike a home equity loan, you don’t have to use your home as collateral.
There are two main types of personal loans: secured and unsecured.
Secured Personal Loans
A secured personal loan uses your assets as collateral. If you can't repay the loan, the lender can take the money from your account to cover the cost. Because there's less risk for the lender, you may be able to get a lower interest rate.
You can use many different assets as collateral, including your home, but you can use other assets besides your home to back a secured personal loan. You can use, for example, a savings account, a stock portfolio, or even your vehicle.
Unsecured Personal Loans
An unsecured personal loan doesn't require collateral. However, that means there's more risk for the lender since they could lose money if you can't repay the loan. As a result, it’s harder to qualify for these loans.
You may need good or excellent credit to get approved for an unsecured personal loan. And even with excellent credit, you’re likely to still pay a higher interest rate compared to a secured loan or a home equity loan.
Credit Cards
Credit cards can be other alternatives to home equity loans. However, use them carefully because they generally have higher interest rates.
You could finance a project with your credit card and pay it off over time. Some credit cards offer a 0% APR promotional period in which you won’t accrue interest on your purchases until the promotional period expires. If you can pay it down before the 0% APR period ends, you essentially get a free loan. However, after that period, interest is applied to your remaining balance.
Read the fine print carefully because some carry a penalty APR as well as other potential fees or penalties.
Other Asset-Backed Loans
Other collateral loans may be a good fit for your financial situation. Here are three types to consider.
401(k) Loans
If you have a retirement 401(k) account, which is an employer-sponsored account, you may be able to borrow money from it. With this type of loan, you can borrow up to $50,000 or half of your account balance, whichever is less. However, the loan typically must be repaid within five years.
One significant downside of a 401(k) loan is that you’re borrowing from future retirement funds.
Car Title Loan
A car title loan can provide cash in an emergency. However, these short-term loans, which often last for only 30 days, have very high interest rates.
You’ll give the title to your vehicle to the lender until the loan is repaid. If you can’t pay back your loan on time, you’ll pay a large fee and could potentially lose your car.
CD Loan
You can use just about any personal property as collateral for a loan, including the value in a certificate of deposit (CD). In a financial emergency, this type of loan allows you to access the money in your CD without paying an early withdrawal penalty. Check with your bank regarding other potential fees.
How Much Equity Do You Need for a Home Equity Loan?
Although lending requirements vary, you’ll typically need at least 15% to 20% equity to qualify for a home equity loan. Of that amount, you can typically take out 80% to 85% as cash.
How Long Does It Take to Get a Home Equity Loan?
There’s quite a bit of paperwork involved when you apply for a home equity loan. The process can take about 45 days, although some lenders might be a bit faster or slower.
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