- Home equity loans are first or second lien mortgages that allow homeowners to convert a portion of their home equity into cash.
- Because home equity loans use real estate as collateral, they typically offer better interest rates than unsecured alternatives like credit cards and personal loans.
- HELOCs (home equity lines of credit) may be a better option for homeowners who prefer the flexibility of borrowing in increments rather than in a lump sum.
Your home is so much more than shelter or a place to make happy memories. It’s also a pillar of financial stability and strength. Owning a home allows you to build equity as property values increase and your mortgage debt is paid down. And some of this equity can be tapped to provide access to cash when you need it.
One of the most popular ways to convert equity to cash is through a home equity loan. In this article, we'll explain what home equity loans are and how they work. You’ll also learn the pros and cons of home equity loans so you can decide if this is the right solution for you. And we’ll also provide multiple alternatives to home equity loans for those seeking other options.
What Is a Home Equity Loan?
A home equity loan is a first or second lien mortgage that allows you to convert a portion of your home equity into cash.
What is Home Equity?
Home equity is the current value of your home minus the balance owed on your mortgage.
With a home equity loan, you can leverage the value of your home to access a specific amount of money that can be paid off in installments over time.[1]
What Are Home Equity Loans Used For?
- Home equity loans can be used for a wide range of purposes, including:
- Covering an unexpected expense
- Financing home renovations or repairs
- Consolidating existing debts
- Starting a business
- Buying a second home or vacation property
- Paying for college
How Does a Home Equity Loan Work?
The home equity loan process begins with an estimate of how much equity is available in your home. Use an online home equity calculator to see how much you may potentially be able to borrow. As a general rule, lenders do not allow homeowners to borrow more than 80% of their home equity.[1]
To apply for a home equity loan, you need to complete an application, submit financial documents, and authorize the lender to check your credit. This information will be used to determine if you qualify for a home equity loan and what interest rate the lender could offer.
Interest rates are typically fixed, meaning that the rate remains the same throughout the term of the loan.[1]
Before the application can be approved, the home will need to be appraised to confirm its current market value.
As with any loan type, there will likely be fees and closing costs associated with issuing the loan.[1] These expenses may be rolled into the loan, so you can repay them as part of your monthly payments rather than paying them upfront.
Once the loan is approved, the amount becomes available in a lump sum. You will then repay the loan by making regular payments of principal and interest.
It is important to note that home equity loans use the home as collateral. This means failure to repay the loan could result in the foreclosure of the property. Therefore, you should only use a home equity loan if you are entirely sure the payments can be made on time and in full each month.
Pros and Cons of Home Equity Loans
The benefits of a home equity loan include:
- Access to a lump sum that can be spent or invested as you choose.
- No annual fees or ongoing account maintenance expenses.
- Lower interest rates than unsecured debt in most cases. One notable
exception is a credit card with a 0% introductory APR. - Predictable monthly payments resulting from a lump-sum payout with a
fixed interest rate. - If the money is used to repair or make improvements to your home, the
interest may be tax-deductible. Always seek advice from a tax professional
before making decisions based on tax implications.
Potential disadvantages of a home equity loan include:
- The possibility of foreclosure on your home if the loan is not repaid.
- Loan origination fees and closing costs.
- Difficulty establishing how much money to borrow. Borrow too little, and
you may have to apply for another loan. However, if you borrow more than
you need, you’ll incur higher fees and interest expenses than necessary.
Alternatives to Home Equity Loans
If you need access to cash but feel a home equity loan isn’t the right move, consider these alternatives.
Home Equity Loans vs. HELOCs
Like home equity loans, HELOCs allow you to borrow against home equity, using your home as collateral. Unlike home equity loans, HELOCs are revolving lines of credit that you can borrow against as needed (similarly to how credit cards are used).[2]
Because you can borrow against a HELOC as needed, HELOCs are a good alternative for those who don’t know exactly how much money they’ll need. Home renovations, for example, often deviate from the original budget, so it can be comforting to know that you can borrow more if the project goes over budget (up to the credit limit).
HELOCs have traditionally come with variable interest rates, meaning your rate could go up or down according to market conditions. However, fixed-rate HELOCs are now available for those who prefer the predictability of a stable rate.
Home Equity Loans vs. Cash-Out Refinancing
While a home equity loan acts as a second mortgage to be paid in addition to your first mortgage, a cash-out refinance replaces your current mortgage with a new mortgage under new terms. By replacing your current loan with a new loan with a higher balance, you can pocket the difference between the amounts (minus any fees).
The new refinance loan will be issued with its own interest rate, so cash-out refinancing may be a good option for those who can secure a lower interest rate than the rate on their current mortgage.[3]
Home Equity Loans vs. Personal Loans and Personal Lines of Credit
If you prefer not to use your home as collateral, a personal loan or line of credit might be a better fit.
Like with home equity options, personal loans can be taken in a lump sum or as a revolving line of credit. Unlike home equity options, personal loans are unsecured, meaning they do not require collateral. The lack of collateral means the lender cannot foreclose on your home in the event of default. However, credit limits may be lower, and interest rates may be higher without collateral.[4]
Home Equity Loans vs. Credit Cards
Home equity loans may offer more money at a lower interest rate than you can get with a credit card. However, if you can qualify for a credit card with a 0% APY period, you could save money on fees and interest by choosing the credit card. Though, it's worth noting that if you carry a balance beyond the 0% period, you could wind up paying considerably more in interest. Credit cards also have the advantage of a quicker application process and a revolving line of credit to borrow against as needed. Additionally, some credit cards offer rewards like cash back or travel miles, which home equity loans do not.
The Bottom Line
Homeowners can use home equity loans to pull cash out of their properties, often with favorable interest rates compared to unsecured loans.
However, if you prefer a revolving credit line rather than a lump-sum loan, a HELOC may be a better fit. And if you would rather not use your home as collateral, an unsecured personal loan or a credit card with a 0% APY introductory period could provide the money you need without risking foreclosure in the event of default.
Explore multiple lending options to find the solution that best serves your financial goals.
