What Can You Use A Home Equity Loan For?

Homeowners today can tap into their home equity through numerous avenues, with one popular option being a home equity loan. But similar-sounding solutions such as a home equity line of credit (HELOC) and other equity-based products might lead you to wonder, “Exactly what can you use a home equity loan for?” Or perhaps you’re asking, “How are home equity loans different from other equity-based options?”

The simple answer to the first question is that you’ll have a good deal of flexibility with what you can do with the funds. However, it may not always be so straightforward, and you’ll want to know how to make the most of your home equity loan. Let’s take a closer look at this type of loan, its potential uses, how it compares to other options and more.

What Are Home Equity Loans?

A home equity loan is a type of loan where the borrower, who is a homeowner, uses their home’s equity as collateral. The loan amount is determined largely by the value of the property and how much you still owe on your mortgage. In some cases, you can borrow up to 85% of the equity in your home.

You can use the funds for anything, but accessing the money comes at a cost and puts your home on the line if you can’t repay the debt. Homeowners often use the loan funds for large expenses such as a home renovation, or they may use the money for credit card debt consolidation or paying off large bills.

Common Uses For Home Equity Loans

For a number of reasons, money management professionals may suggest that a homeowner use a home equity loan to improve their financial position.

Now, let’s explore some of the most common uses for home equity loans.

Home Improvements

One popular use for a home equity loan is funding significant home improvements or renovations. These projects not only enhance your living experience, but they can also increase the market value of your home – a potential win-win scenario. By using the loan strategically to add value to your house, you’re effectively investing your borrowed funds in a way that can pay off in the future.

Starting A Business

If you’ve harbored dreams of starting a business, a home equity loan might provide the necessary capital. It can help pay for various startup costs, from purchasing equipment to marketing. However, it’s best to have a well-thought-out business plan and consider the potential risks, as your home serves as collateral in this scenario.

Debt Consolidation

Another popular use for home equity loans is consolidating high-interest debts, such as credit card balances or personal loans. By paying off these debts with a lower-interest-rate loan, you can save money on interest in the long run and potentially reduce the amount you shell out in monthly payments.

Home Equity Loan Features

To clearly understand the concept of a home equity loan, it helps to be familiar with the loan’s key features, which include versatility, fixed interest rates, predictable monthly payments and long repayment periods.

Wide Range Of Uses

One meaningful feature of home equity loans is their versatility. In other words, once the loan is issued, the borrower can use the funds however they wish. Home equity loans are often utilized to cover significant life expenses, such as home improvements, high-interest debts and student loans.

Fixed Interest Rate

One of the key features of home equity loans is that they typically come with a fixed interest rate. This means that the interest rate won’t change over the life of the loan, allowing for predictable monthly payments.

Affordability

Home equity loans tend to have lower interest rates than non-equity-based financing options. This can make them a more affordable option than paying for large expenses with a credit card or unsecured personal loan.

Monthly Payments

Home equity loans are repaid through monthly payments over a period of time, often 5 – 20 years. These payments are usually fixed and consistent throughout the loan term, making it easier to budget and plan for the expense.

The Risks And Rewards Of Home Equity Loans

As with any financial tool, home equity loans come with both risks and rewards. Here’s a detailed look at both.

Risks

• The possibility of foreclosure: Since a home equity loan uses your house as collateral, failure to make payments could lead to foreclosure on your home.
• Fluctuating home values: If the value of your home decreases, you may end up owing more than your home is worth if you’ve borrowed a large portion of your equity.
• Extra costs and fees: Home equity loans can come with additional costs, such as closing costs, an appraisal fee and an early payoff penalty.

Rewards

• Lower interest rates: Home equity loans generally offer a lower interest rate than you’ll find with other types of loans or credit cards, making a home equity loan a cost-effective borrowing option.
• A large loan amount: Depending on how much home equity you’ve built, you may be able to borrow all the money you need to cover large expenses or investments.
• Tax-deductible interest: In some cases, the interest paid on a home equity loan may be tax-deductible, providing potential savings come tax time.

Making The Most Of Your Home Equity Loan

To ensure you’re making the most of your home equity loan, it’s essential to plan and strategize carefully. Here are some tips that help you make the most of your loan:

Set a budget. Before borrowing, create a budget to determine how much you need and can afford to repay each month.

Compare lenders. Shop around and compare offers from different lenders to get the best interest rate and term for your loan.

Consider closing costs. Take into account any closing costs or fees associated with the loan when determining its overall cost.

Use the funds wisely. Make sure to use the loan for a purpose, such as home improvements or debt consolidation, that will improve your overall financial situation or add value to something you own.

Have a repayment plan. Create a repayment plan to ensure you can make timely payments and avoid any potential risks or penalties.

Alternatives To Home Equity Loans

While a home equity loan can be a useful financial tool, it’s by no means the only option available to fund large expenses. Next, let’s consider a few equity- and non-equity-based alternatives to home equity loans.

Home Equity Line Of Credit (HELOC)

Similar to a home equity loan, a home equity line of credit (HELOC) allows you to borrow against your home’s equity. However, instead of receiving the full amount upfront, you have access to a line of credit that you can draw from as needed. Interest rates are often variable, meaning they can fluctuate over the life of the loan. This option might be beneficial for those who need funds over an extended period or are unsure of the exact amount they’ll need.

HELOC Vs. Home Equity Loan

• Payout method: A home equity loan provides a lump-sum payout at the beginning of the loan period, while a HELOC allows you to draw funds as you need them during the draw period.
• Interest rate: Home equity loans typically have a fixed interest rate, which makes for predictable monthly payments. On the other hand, HELOCs usually have a variable interest rate, which can fluctuate over time and make monthly payments not so predictable.
• Flexibility in usage: HELOCs offer more flexibility since you can borrow as much or as little as you need within your credit limit during the draw period. A home equity loan, on the other hand, offers a one-time lump sum when you’re approved for the loan.

Cash-Out Refinancing

Cash-out refinancing involves replacing your existing mortgage with a new one, for an amount that’s higher than what you owe. You then receive the difference in cash, which you can use for various purposes. A cash-out refinance may offer a low interest rate or low monthly payment compared to a home equity loan. Given the stark change in interest rates over the last couple years, it’s important to note that a cash-out refinance comes with a new rate, which may be higher than your current rate if you bought a house when rates were lower.

Cash-Out Refinance Vs. Home Equity Loan

• Loan amount: With a cash-out refinance, you can generally borrow up to 80% of your home’s equity, whereas the amount you can borrow with a home equity loan may be up to 85%.
• Loan terms: Cash-out refinancing typically extends your repayment period, as the refinanced loan replaces your original mortgage. A home equity loan, on the other hand, is a separate loan with its own repayment term, which can be shorter than your primary mortgage term.
• Impact on primary mortgage: Cash-out refinancing replaces your original mortgage, which can affect the terms of your loan. In contrast, a home equity loan is a type of second mortgage that doesn’t alter the terms of your original mortgage.

Personal Loans

Personal loans are most often unsecured loans, meaning they don’t require collateral. Putting less on the line can make a personal loan an attractive alternative to a home equity loan. While your interest rate may be higher with a personal loan, it offers a fixed repayment term and can likewise be used for a variety of purposes.

Personal Loan Vs. Home Equity Loan

• Collateral: A home equity loan uses your house as collateral. If you default on a home equity loan, you could lose your house. Personal loans are most often unsecured, in which case they don’t require any collateral.
• Loan amount: With a home equity loan, you can potentially borrow a larger amount based on the equity in your home. The loan amount for an unsecured personal loan is usually smaller and is based on your credit score, income and other personal financial factors.
• Use of funds: Accessing funds through a home equity loan can involve significant closing costs, so most borrowers use a home equity loan for large investments or expenses. Personal loans tend to be smaller and cost less to access, and they’re useful for a variety of purposes, including vacations, weddings and other personal expenses.

The Bottom Line

Whether for home improvements, consolidating debts or addressing larger expenses, taking out a home equity loan can be a wise move and provide the financial leverage you need.

But, because of the risks associated with home equity loans, the decision to pursue one is a decision a homeowner shouldn’t take lightly. Understanding your financial goals, assessing your ability to repay and exploring this loan’s potential impact on your overall financial health are critical.

To keep an eye on your finances and see how a home equity loan will affect your budget, download the Rocket Money^℠ app today.