Home equity loans are a common option for homeowners to obtain financing for various uses. Relative to other forms of financing, equity loans provide low interest rates and tax deductions. However, there typically are greater risks with a secured equity loan than with other forms of borrowing.
Home Equity Loan Benefits
A primary motive for taking out a loan with your house as collateral is the interest rate. Your rate normally is much lower than a rate associated with a similar unsecured personal loan or credit card. The risks of extending financing are lower for a bank because the loan is backed by your property. If you don't pay, the lender can enter foreclosure and attempt to seize possession of the house.
Other core benefits of an equity loan include:
Tax deduction - The interest you pay on a home equity loan usually is tax deductible. This tax break is similar to the interest deduction for your primary mortgage. Added to the already low interest rate, your net financing costs are even lower.
Lump sum payment - Equity loans are distributed with a single lump sum payment, which works better than a home equity line of credit or credit card account for borrowers who need a set amount. You can use the one-time fund distribution to pay for a home improvement project, college or overwhelming medical bills.
Not all borrowers benefit from tax breaks with an equity loan. You must itemize your taxes, for instance, to claim an individual deduction for the interest.
Home Equity Loan Drawbacks
A home equity loan puts a couple of key restrictions or limitations on your property usage. First, if you don't repay the debt, you risk losing your house to the bank. Second, if you decide to sell your home with unpaid debt remaining, you must repay the borrowed amount with funds from the sale.
Other core drawbacks of an equity loan include:
Costs and fees - Despite the low interest rate, you may pay several thousand dollars in closing costs and finance fees to take out a sizable equity loan, according to the National Association of Realtors. Also, taking out a 15-year or 30-year equity loan for a modest sum could cost you a lot more in interest over time than using revolving credit to cover the expense.
Unscrupulous lenders - Some lenders promote equity loans to people in desperate financial situations, such as those underwater on other loans or with overwhelming credit card debt. Debt consolidation is a common motive for an equity loan, but beware of potentially unfavorable loan terms, such as high early payoff fees or loan processing fees. Comparing financing costs from a few lenders helps protect against these hidden costs.
A cash-out refinance where you take on a new primary mortgage and package in an equity payout is an alternative to an equity loan. However, some homeowners prefer the flexibility of two separate loans and paying off the equity loan separate from the first mortgage.