Home equity loans can be used for just about anything, from consolidating debt to making home improvements and covering emergency expenses. Tapping your home’s equity might make sense if your home has increased in value and your income is stable, but there are risks.
Here’s what to consider before you apply for a home equity loan in today’s economic climate.
[SEE: Best Home Equity Loans]
Does It Make Sense to Borrow a Home Equity Loan Now?
American homeowners have seen their equity surge over the past few years as home values appreciated at a double-digit pace.
From the onset of the COVID-19 pandemic through the beginning of 2024, home prices have increased by 48%, per the Federal Housing Finance Agency. And the average tappable equity per mortgage borrower rose to a record high of $214,000 in the second quarter of 2024, according to ICE Mortgage Technology, a data provider for the housing finance industry.
However, high interest rates in recent years may have discouraged homeowners from tapping that massive sum of equity they’ve built. Rates on home equity loans — and especially shorter-term home equity lines of credit — are influenced by the Federal Reserve’s monetary policy, and the central bank raised its target interest rate 11 times in 2022 and 2023.
The Fed is expected to implement a series of rate cuts gradually over the next two years, which means that home equity interest rates should follow suit. In other words, home equity loans could become cheaper for homeowners who can afford to wait for rates to fall.
Remember that rates on home equity loans and HELOCs are influenced by the Fed rate, but they’re also moved by greater economic conditions, as well as the applicant’s credit score. You have a bit more control over the interest rates you’re offered if you have excellent credit.
And it’s not always a good idea to borrow against your home’s equity. You could technically save money on a home equity loan when interest rates fall, but in reality, you’ll never ‘saving money’ when you borrow money at interest.
Pros and Cons of Home Equity Loans
Pros
— Fixed payments. Because a home equity loan is an installment loan with a fixed interest rate, your monthly payments are predictable over the life of the loan. This can help you plan your budget.
— Lower interest rates compared with credit cards and personal loans. That’s because home equity loans are secured, so they’re less risky for lenders compared with unsecured debt. And if you pay off the home equity loan early, you stand to save even more on interest costs.
— Tax deductions. If you use the home equity loan for eligible home improvements, you may get a tax deduction on interest payments.
Cons
— You have to go through the closing process. You can expect to pay around 2% to 5% of your loan amount in home equity loan closing costs. Plus, it can take weeks to close on a home equity loan, and you’ll have to submit to a home appraisal.
— You risk foreclosure. A home equity loan is secured by the equity in your home. If you fall behind on payments, the lender may start foreclosure proceedings on your home. Taking one of these loans is especially risky in an unstable job environment.
— Your equity drops. You won’t get back the equity you lost until you pay off the loan, and you may end up underwater on the loan if home prices fall. “We advise caution,” says Melinda Opperman, chief external affairs officer at Credit.org, a nonprofit credit counseling agency. “Keeping your homeownership stake intact is a very safe place to store the wealth you’ve built up. Even if there’s another housing crash, you still have a roof over your head.”Website LinkedIn
[READ Best HELOC Lenders]
Alternatives to a Home Equity Loan
Home Equity Line of Credit
As with a home equity loan, a HELOC allows you to borrow against the value of your home. But it works like a credit card, so you don’t take out money until you need it.
With a home equity line of credit, you only pay interest on the amount of money you actually use out of your credit limit, whereas with home equity loans, you’re paying interest on the entire amount borrowed. If you’re looking to save money on interest, HELOCs have the upper hand in that you have a bit more control over how much you borrow.
During the draw period, you can borrow money, pay down your balance and repeat. But proceed with caution — like with a home equity loan, you risk losing your home if you fall behind on payments.
Cash-Out Mortgage Refinancing
Cash-out refinancing offers a different way to tap your home’s equity. With a cash-out mortgage refinance, you replace your current mortgage with a new, larger mortgage and pocket the difference.
When you borrow a home equity loan or HELOC, you’re left with two payments, which is why these products are sometimes referred to as second mortgages. But cash-out refinancing leaves you with just a single housing payment.
Mortgage refinancing might be a good idea if you can land a lower mortgage rate than you’re currently paying. Homeowners who bought when mortgage rates peaked in October 2023 might be able to lock in a lower rate by refinancing — however, those who bought recently may not have very much tappable equity to justify a cash-out refinance.
On the other hand, those who bought when rates were low in 2020 and 2021 likely have sufficient equity but ultralow mortgage rates. Cash-out refinancing would mean giving up that low rate to cash in on your home’s equity, which might not be worthwhile.
Personal Loan
A personal loan may come with a higher interest rate than a home equity loan, but it’s typically unsecured, meaning no collateral is at risk. Missed payments would hurt your credit, “but you wouldn’t lose your home because you lost your job and you’re unable to make the payments,” says Bola Sokunbi, certified financial education instructor and founder of Clever Girl Finance, a personal finance website for women.
Like home equity loans and HELOCs, personal loans are often used to pay for home improvements or consolidate debt. You’ll have to get prequalified to compare personal loan offers to determine if the benefit of having unsecured debt is worth paying a higher rate.
But as an advantage, personal loans can close relatively quickly compared with home equity loans and HELOCs. You might receive funding as soon as the same day you’re approved.
[Related:Personal Loan vs. Home Equity Loan: Which Is Better?]
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Should You Get a Home Equity Loan Now? originally appeared on usnews.com
Update 08/26/24: This story was previously published at an earlier date and has been updated with new information.
