Solved! What Are the Advantages of a Home Equity Loan?

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Q: I need some extra cash to make repairs on my home and pay off some debt, and I’ve heard a home equity loan may be a good option. What is a home equity loan, and how does it work? And what are the advantages of a home equity loan?

A: Accessing money for home projects is just one of the advantages of a home equity loan. The best home equity loans allow homeowners to borrow against the equity they have in their homes. As with many borrowing options, this does require paying interest, and the loan will need to be repaid. However, homeowners can use the cash from this type of loan for just about anything, whether it’s paying off other debts or unexpected medical bills. However, if a homeowner defaults on the loan, their home could go into foreclosure. Read on to see if a home equity loan is right for you.

A home equity loan provides homeowners with a lump sum of cash borrowed against the equity they have built in their home.

What is a home equity loan? And how does a home equity loan work? When homeowners take out a home equity loan, they are borrowing from the equity they have in their home. Home equity is simply the difference between what’s owed on the mortgage and the value of the home. That equity could come from the homeowner making regular mortgage payments over a longer period of time, or even from the value of the house increasing over time. The homeowner can borrow a certain amount of money in one cash-out payment to do with whatever they choose. The homeowner then pays back that amount in installment payments, usually monthly.

The payments on a home equity loan include the amount of money borrowed as well as the interest. Sometimes additional fees associated with processing the loan may also be rolled into the loan to be repaid.

It’s also important to keep in mind that many lenders do not allow anyone who has less than 20 percent equity built into their home to take out a home equity loan. So if a homeowner has less than that amount in home equity, they may have to wait in order to qualify for this type of loan.

Home equity loans are relatively easy to qualify for compared to other types of loans.

One of the main advantages of a home equity loan is that it is often easier to qualify for than other types of loans. How do home equity loans work? The loan is secured using the home as collateral. That makes it less of a risk to lenders than other types of loans, such as personal loans, which are unsecured. However, since the home is used as collateral, not paying the loan could send the home into foreclosure. More on that will be covered below.

Many homeowners can also access a home equity loan quite easily through the same lender that handles their mortgage. However, it can also be important for homeowners to shop around with credible lenders to make sure they are getting the best rates and terms.

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Homeowners can use the money from a home equity loan for any purpose.

A massive draw toward home equity loans is that the money secured can be used for anything. It’s common to use the money to make needed repairs or additions to the home. Some people use it for unexpected medical bills that would otherwise require more expensive personal loans or even having the bills go into a debt collection cycle. Homeowners can even use the money to pay for education. Another common use is paying off or consolidating debt, such as getting rid of high-interest credit card debt.

A home equity loan doesn’t come with any strings attached regarding how a homeowner uses the money. The lump sum of cash gets deposited, and it’s up to the homeowner to choose what to do with it.

Using the money from a home equity loan for home improvements may increase the value of the home.

One of the reasons a home equity loan is so popular for home improvement projects is because those home improvements could actually increase the value of the home. If a homeowner takes out a home equity loan to finish their basement, for example, then that could actually increase the home’s value.

It’s important to remember that not all home improvements add value. In general, home improvements that add space or make better use of existing space can be a good return on investment. But a lot of the return on investment will depend on the home’s location and the state of the housing market. In a seller’s market, a renovated home may sell for much more than it would if it were in its original state, but in a market downturn a homeowner may actually lose money selling their home, even if they have put money into improving it.

Home equity loans have fixed rates for the life of the loan, and the rates are typically more favorable than those of personal loans.

One of the advantages of a home equity loan is that they tend to have fixed rates for the term of the loan. While taking out a home equity loan can carry the risk of foreclosure due to using the home as collateral, the fact that the loan has a fixed rate means that the loan payment is steady and predictable and will not increase if interest rates rise, which reduces some of the risk.

Further, home equity loan rates tend to be better than personal loan rates. Since the lender has used the home as collateral, they determine the loan to be less of a risk and can often give better interest rates. A personal loan might have higher interest rates to cover the risk of not using any type of collateral.

Like mortgages, home equity loans tend to have long repayment terms, making monthly payments relatively affordable.

Home equity loans can typically be repaid anywhere between 5 and 20 years. Homeowners can pick payment terms that work for them. If they decide they want a smaller monthly payment over a longer term, they can often work that desire into the loan terms. Homeowners who want to pay off the loan quicker and are comfortable with a larger monthly payment also have that option.

However, it’s important to keep in mind that the loan payments will be in addition to regular monthly mortgage payments. For this reason, homeowners should carefully assess the loan payments to make sure they fit into their monthly budget on top of the mortgage payment; otherwise, they could risk losing their home.

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The interest on a home equity loan may be tax deductible.

The Tax Cuts and Jobs Act of 2017 suspended the deduction for interest paid on home equity loans and lines of credit, with one exception. If the homeowner uses the money from a home equity loan to “buy, build, or substantially improve” their home, they will likely be able to deduct that interest from their tax return. However, if the homeowner uses the funds from the home equity loan to pay outstanding medical bills or to pay for a child’s college tuition, the interest will generally not be tax deductible.

However, it’s important to note that other restrictions can apply. For example, the loan must be secured against the borrower’s primary or secondary residence. Homeowners may want to work with a tax professional to verify what is tax deductible and what is not as it relates to their home equity loan, especially since rules can change.

Since a home equity loan uses the home as collateral, defaulting could result in the homeowner losing their home to foreclosure.

One of the most critical things to know about a home equity loan is that it does open up the homeowner to further risk of foreclosure. As mentioned above, the home is used as collateral when taking out the home equity loan. If the homeowner cannot pay the loan amount, that can result in the home moving into a state of foreclosure. If this happens, the homeowner will lose not only their equity but also their home.

As such, it’s important to fully assess the risk involved. Since the loan amount is paid by homeowners on top of the regular mortgage payments, the loan payments will need to fit into the monthly budget comfortably. If the homeowner’s monthly income is not enough to cover the mortgage, home equity loan payment, and other fixed expenses, then they should not take on a home equity loan.

Further, since not paying the loan could result in losing the home, homeowners might not want to use a home equity loan for something risky. For example, using the home equity loan amount to start a business is a dangerous proposition because if the business were to fail and the homeowner could not make the loan payments, they could end up losing their home as well as their business. A better option in this case may be a loan from the Small Business Administration.

Generally, a home equity loan is an attractive option for homeowners with equity who need a lump sum of cash.

While it is important for the homeowner to be comfortable using their home as collateral and able to make the loan payment as scheduled, home equity loans do remain a popular loan option because they immediately allow a homeowner to access that lump sum of cash. If a large expense comes along or a homeowner wants to complete a major home project, the loan may be a beneficial way to access equity in the home.

It can also be one of the least expensive ways to access loan money. Remember, the interest rates for home equity loans tend to be much more favorable than those for other types of loans (such as personal loans). And a homeowner is technically accessing their own money, whether it’s from the money they’ve already paid toward the mortgage or because the value of the home has increased. Further, the interest paid on a home equity loan might be tax deductible, and longer loan terms may mean lower and most customizable payments.