Is A Home Equity Loan A Good Idea?

Accessing home equity can be a good way for many homeowners to accomplish their goals, whether they be financial or home improvement-based. However, there are many ways of going about converting the equity in your home into the money you need. Is a home equity loan a good idea for you or would it be better to take a look at another option?

Homeowners with enough equity in their home might find that a home equity loan suits their needs, especially to fund major home improvements. A home equity loan can also be a solid option for debt consolidation or funding a large purchase. But you’ll need enough equity in your home – and you’ll have to accept the risk of losing your home if you don’t pay the loan back in the time frame agreed upon. Understanding alternative options can also help you make the best decision for your goals.

What Is A Home Equity Loan And How Does It Work?

A home equity loan is a secured loan using your house as collateral. It’s taken out in addition to a primary mortgage by homeowners who want to take advantage of their existing home equity but want to avoid refinancing out of a low rate on their primary mortgage. Whether it makes sense to get a home equity loan or something else comes down to math.

Homeowners who take out a home equity loan will receive the funds in a lump sum. The funds can be used to help consolidate debt at a lower interest rate or for any number of home improvement projects, among other uses. They can either have a fixed interest rate or an adjustable one and are paid back in monthly installments over the life of the loan.

The amount you can borrow is dependent on your loan-to-value ratio (LTV). This is determined by comparing the size of both your primary mortgage and your new home equity loan to the value of your home. Our friends at Rocket Mortgage® allow you to borrow up to 90% of the value of your home, depending on credit and other qualifications with a 10- or 20-year fixed term.¹

Is A ‘Second Mortgage’ The Same As A Home Equity Loan?

A home equity loan is a type of second mortgage, so named because you’re taking on a second mortgage payment in addition to your primary home loan. Other terms for a home equity loan include HELoan or closed end second. This shouldn’t be confused with a home equity line of credit (HELOC), which is another type of second mortgage.

Pros And Cons Of A Home Equity Loan

Like any financing option, a home equity loan has pros and cons. Let’s go into more detail on each.

Pros

• No need to touch your primary mortgage: You can utilize this loan while avoiding refinancing your primary mortgage. This could be advantageous if the current rate on your first mortgage is significantly lower than prevailing market interest rates.
• Option for a fixed interest rate: While adjustable-rate home equity loans are also available from some lenders, having a fixed rate means the payment is consistent throughout the loan term.
• Funding flexible for many uses: You can use the money from a home equity loan for whatever you wish. Commonly, they’re used for debt consolidation or home improvements, but they could be used for investments or any other purpose as well.
• Interest could be tax deductible: The IRS considers interest paid on home equity loans to be tax deductible to the extent that the money is used to buy, build or substantially improve your home. The limit on mortgage debt with deductible interest is $750,000 ($375,000 if married filing separately) if the debt was taken out on or after December 16, 2017.

Cons

• Foreclosure risk: Any time you take out a loan secured by your home, there’s a chance of losing it if you can’t make the payments. While this isn’t any different than a primary mortgage in this respect, it’s always a good idea to make sure you’re not stretching yourself too thin.
• Multiple mortgage payments: When you take on a second mortgage, it’s important to note you’ll have to juggle two mortgage payments, one for your primary mortgage, and one for the home equity loan.
• Decrease in home equity: While your equity is converted into cash to be used for other purposes, this does mean you’ll have less equity going forward until the loan is paid off. If you sell your home while still having your home equity loan in place, you’ll have fewer proceeds.
• Higher interest rate relative to primary mortgage: The rate on a second mortgage will typically be higher than your first mortgage because the primary mortgage holder gets paid first in the event of default. For this reason, it’s important to do some math and really make sure a home equity loan makes more sense than another alternative.

Home Equity Loan Pros And Cons At A Glance

Now that we’ve touched on the benefits and disadvantages, here is a condensed version of the points made above as a quick reference.

When Home Equity Loans Aren’t A Good Idea

When considering a home equity loan, the first thing to focus on is the goal you’re looking to accomplish. While this loan may be good for debt consolidation, it doesn’t mean it’s the most suited option in every debt-related case. An example of this is student loan debt.

If you’re looking to consolidate federal student loan debt, consolidation options offered through the Department of Education may offer a lower rate than anything you can get using your home equity.

Also, no matter your reason for taking out a home equity loan, you’ll want to make sure that you work with your Home Loan Expert and do a blended rate calculation. This involves finding the weighted average interest rate of the different loan options that may be available to you to make sure you’re taking the loan that makes the most sense financially.

How To Get A Home Equity Loan

The process for getting a home equity loan is very similar to applying for a primary mortgage. Your lender will pull your credit report to get a look at your credit score and outstanding debts. You’ll want to have fairly good credit and a low debt-to-income ratio (DTI) to give yourself the most borrowing power.

Rocket Mortgage requires a DTI no higher than 45% to go along with a qualifying credit score no lower than 680 for a home equity loan. It’s important to note that higher credit scores will help you qualify to access more of your equity relative to the value of your home.

You can expect similar closing costs and origination fees to those of a traditional mortgage.

Alternatives To Home Equity Loans

Home equity loans can be one great way of accomplishing home improvement or financial goals, but there are alternatives that could work better depending on your situation.

Home Equity Line Of Credit (HELOC)

A home equity line of credit is a type of loan backed by your home, but unlike a home equity loan or cash-out refinance, this one works more like a credit card in that the balance can change on a monthly basis for the first part of the loan. This provides flexibility to use it for projects or opportunities and put the money back in to the line for use again when the next chance comes.

A HELOC has two distinct periods. During the draw period, you can take out up to the limit of your credit line and put it back in as many times as you want to fund your objectives. You only need to pay interest on what you borrow. After the draw period comes the repayment phase, when the balance freezes and you spend the rest of the term paying back principal and interest.

Some lenders, including Rocket Mortgage, don’t offer HELOCs, so you may have to shop around if this is something you’re interested in. Additionally, most of these feature rates that are adjustable or even variable, so the payment could change as frequently as every month even if it’s based on the same balance.

Personal Loan

A personal loan is one that’s not secured by any property, which can be a major attraction for some. While the interest rates tend to be higher than secured loans, it can make financial sense to do a personal loan depending on how the fees work out.

It’s worth noting that the loan amount you could receive tends to be significantly lower than you could get with a loan backed by collateral. Additionally, the repayment term tends to range from 3 – 5 years.

Cash-Out Refinance

A cash-out refinance involves changing the terms of your primary mortgage to take on a bigger balance. Mechanically, it works the same way as a home equity loan in that you get a lump sum payment. You also only have one monthly payment to worry about.

The interest rate is lower on a cash-out refinance than it would be on a home equity loan because it’s based on your primary mortgage. However, depending on the rate environment, you could be giving up a low rate on your existing mortgage for a higher one. This is where a blended rate calculation will come in handy to compare a cash-out refi with a home equity loan.

Home Improvement Loan

When speaking of a home improvement loan, you could be referring to a home equity loan, HELOC, personal loan or cash-out refi. But one we have yet to speak about is a rehabilitation loan. This is a type of refinance used specifically to buy or refinance a home while at the same time fixing it up through major remodeling.

The major benefit of these loans is that you don’t have some of the extra origination charges that come with a cash-out refinance. So the financing can be slightly less expensive. The downside here is that you have to use the loan on your home, so you have less flexibility than you would with a home equity loan or some others we’ve discussed.

Credit Cards

People often use credit cards for major purchases or home improvements. They can even be used for debt consolidation because you can take advantage of 0% or low introductory annual percentage rates (APR) to do a balance transfer and pay off high-interest debt during the introductory period.

However, it’s very important to have a plan for paying off your purchases quickly. If not, the interest rates on credit cards can make carrying a balance prohibitively expensive.

FAQs: Are Home Equity Loans A Good Idea?

Now that we’ve run through the ins and outs of home equity loans and the various alternatives, let’s answer several other questions you may have.

What is the downside of a home equity loan?

The most obvious downside is that it’s backed by your home. If you can’t make the payments, your home can be taken. You also have to juggle two payments. Finally, you have to do some math to figure out whether it makes sense to take a home equity loan or do a cash-out refinance because there’s no surefire answer.

Is it a good idea to borrow from my home equity?

This is something that comes down to your goals and the math. If you’ve crunched the numbers and looked at your home loan options and borrowing from your home equity gets the job done, it’s probably a good idea. For others, a home improvement or personal loan might make more sense.

What is the monthly payment on a $50,000 home equity loan?

There’s no right answer to this question because it depends on the interest rate and the term of the loan. For the sake of an example, let’s say the interest rate was 9.5% over 10 years. The monthly payment on this $50,000 home equity loan would be $646.99.

Is a home equity loan a good idea to pay off debt?

To get a real answer to this, you need to compare a home equity loan to your other loan options by doing a blended rate calculation. A Home Loan Expert can likely help you with this because it’s a purely mathematical equation. You’re also not paying off debt so much as you are consolidating it at a lower interest rate.

The Bottom Line: A Home Equity Loan Can Be A Solid Option Under Certain Circumstances

A home equity loan is a second mortgage with a lump sum payment used by those who want to turn their home equity into cash without changing the interest rate on their current mortgage. Whether it makes sense go forward with a cash-out refinance or another alternative comes down to how the math works out. You’ll make two payments with a home equity loan.

If you’re interested in looking into a Home Equity Loan or cash-out refinance, start an application with our friends at Rocket Mortgage.

Looking for something to help with your budgeting and credit goals? Download the Rocket Money^SM app.

¹ Home Equity Loan product requires full documentation of income and assets, credit score and max loan-to-value (LTV), combined loan-to-value (CLTV), and home equity combined loan-to-value (HCLTV) ratios. Requirements were updated 2/5/2024 and are tiered as follows: 680 minimum FICO with a max LTV/CLTV/HCLTV of 80%, 700 minimum FICO with a max LTV/CLTV/HCLTV of 85%, and 740 minimum FICO with a max LTV/CLTV/HCLTV of 90%. Your debt-to-income ratio (DTI) must be 50% or below. Valid for loan amounts between $45,000.00 and $500,000.00 (minimum loan amount for properties located in Michigan is $10,000.00). Product is a second standalone lien and may not be used for piggyback transactions. Product not available on Schwab products. Guidelines may vary for self-employed individuals. Some mortgages may be considered “higher priced” based on the APOR spread test. Higher priced loans are not allowed on properties located in New York. Additional restrictions apply. Not available in Texas. This is not a commitment to lend.