Home equity loans are back nearly a decade after the subprime mortgage crisis. Today homeowners have more equity to draw from, fewer are underwater, and banks are lending more responsibly to borrowers who are likely educated about smart ways to purchase a home. While there are a lot of reasons to consider a home equity loan or HELOC (home equity line of credit), it's still debt. Here are some of the biggest pros and cons of home equity loans and HELOCs to help you decide.
The Motley Fool reports that home equity accounts for the biggest chunk of the average American's net worth -- about one third. Of course, the problem is that most of us won't see any of that money until selling our homes. Home equity loans and HELOCs, on the other hand, allow borrowers to draw on that cash while staying put in their homes.
Home equity loans are secured debt, which means the bank can take collateral -- your home -- if you don't pay. Know all payment terms before signing a contract. Home equity loans are fairly straight-forward, with fixed payments over a certain term. Still, the payments on HELOCs can jump once the interest-only period ends.
Though it's called a home equity loan, that doesn't mean the money can only be used for home-related expenses. Unlike a primary mortgage or car loan, the cash is yours to use as you wish, whether that's to pay for college, tackle medical bills, pay off higher-interest credit cards, or buy big-ticket purchase.
While experts say it can make sense to use home equity for essential home improvements, an emergency fund, or college expenses, blowing equity on frivolous expenses is what led many into foreclosure during the housing crisis. Find another way to pay for that trip abroad, luxury car, or dubious home project that may not add value (think swimming pool).
Just like a primary mortgage, the interest on a home equity loan is tax-deductible. The limit is typically the interest on a loan up to a $50,000 for an individual, and $100,000 for a couple, according to MortgageLoan.com. If you use the money purely for home improvements, the limits take a healthy jump to $500,000 and $1 million respectively, because the IRS considers that a different kind of debt.
A common reason to tap your home equity is the need to tame high-interest credit-card debt. But paying off your credit cards this way won't fix the underlying issue -- overspending -- that created the debt in the first place. Use home equity loans for credit-card debt only if you have the financial discipline to put the credit cards away for good.
Need a big lump sum? It's possible to get a large amount at once with a traditional home equity loan. If you have an ongoing financial need and are unsure how much you'll need, a HELOC is probably the better bet. Draw on the line of credit as you need cash for as long as you stay under your credit limit. In either case, if you have a lot of equity, you can usually borrow a lot, too.
To qualify for a home equity loan or line of credit, you need to have enough equity in your home -- often up to 20 percent of the home's value after the home equity loan or line of credit is typical. If you owed $100,000 on a $150,000 house, $20,000 would likely be the extent of the loan. That would leave $30,000, or 20 percent, in equity.
Average interest rates for both home-equity loans and lines of credit were hovering around 5.3 percent at the beginning of October 2017. That's a lower rate than most personal loans, which are often floated as an alternative to home equity loans, and it's certainly much lower than the interest rate on most credit cards.
You'll still need excellent credit to nab the best interest rates. Someone with a credit score over 740 could nab a 10-year, $50,000 loan with an average APR of 5.8 percent, according to October 2017 national averages from myFICO. A score of 620 would only net an average APR of 10.1 percent. The person with the better credit score would be paying around $549 a month, while the person with average credit would owe $663 a month.
While you may not be able to get a personal loan or unsecured credit card with average or poor credit, a home equity loan or HELOC is still a possibility because the loan is backed by your home. The chances of getting a loan with average or poor credit are even better if you have a lot of equity in your home.
Need cash quickly? A home equity loan won't solve your problem. It can take two to six weeks for a lender to gather all the necessary paperwork and verify your finances. It can also take years to build the equity needed for a loan, making home equity loans a no-go for recent buyers.
For the lowest possible interest rate, a HELOC can offer that. The catch? The rate is variable, and it can rise as easily as it can fall. More risk-averse owners will find a fixed rate home equity loan the better choice. Don't assume the HELOC will be the best choice, since those rates have risen.
While you get a lump sum right after closing on a traditional home equity loan, a HELOC is trickier. The lender can shrink or even suspend your HELOC under certain circumstances, such as if your home value plummets, you default on part of the loan agreement, or your finances take such a hit your lender thinks you'll have trouble making payments, warns the Consumer Finance Protection Bureau.
One of the best and most common uses for home-equity loans and HELOCS is using the money to finance renovations. Chosen wisely, they can boost your home's value and help an owner turn a profit when they sell. Just be sure to focus on the right things. Adding fiberglass insulation to a drafty attic pays, but a costly bathroom addition may only return half your investment, according to Hanley Wood.
Hoping to sell your home soon? Wisely-chosen renovation projects may be of great interest to some buyers, but little else will boost the value of your home -- thus making it harder to repay the loan.
It's common for home equity loans to have closing costs similar to those of a primary mortgage, while HELOCs have few or no closing costs. Interest.com notes it's getting easier to find no-closing-cost options regardless of whether you go for a traditional home equity loan or a HELOC.
Those no-closing-cost loans may require reimbursement for those costs if you pay back the loan within two or three years. There may also still be appraisal fees and annual account fees. Watch out for transaction fees for each withdrawal, as well as inactivity fees for when there's too much time between withdrawals.