If you don’t have much money in the bank but own a home, you have access to a huge asset. Depending on how large of a down payment you made and how much your home’s value has increased, you could have thousands in home equity — the amount of money your home is worth relative to the amount you still owe. It’s enough to make anyone feel rich.
Many people take out a home equity loan to pay for home improvements, big purchases, or even pay down debt. With low interest rates, it can be an appealing option.
However, home equity loans can have serious consequences. This type of debt can sometimes be a gamble; fall behind on payments and you could lose your home.
What is a home equity loan?
A home equity loan (HEL) is a way to borrow money at a low interest rate to make a big purchase or pay off debt. In fact, fixed interest rates can be as low as 4.5% or 5%.
The reason the rate is so low is because the loan is a secured form of debt, meaning you have to provide collateral to borrow the money. With HELs, the collateral is your home.
Unsecured loans, such as personal loans, do not require you to have collateral. Without anything guaranteeing the loan, lenders set higher interest rates to offset their risk.
According to the Federal Trade Commision, the amount you can borrow through an HEL is typically limited to approximately 85 percent of your home’s equity. However, the loan amount and terms are dependent on other factors, too. Lenders will also review your credit report, income, and the current value of your home.
How does a home equity loan work?
Your home’s equity is the current appraised value of your home minus what you owe on it today. For example, if you own a $200,000 house and you owe $150,000 on it, your home equity is $50,000.
If you qualify for an HEL, you might be able to borrow up to 85 percent of the home’s equity. In the example above, you could borrow up to $42,500.
Most banks and credit unions offer HELs, and the loans come with a set repayment term and monthly payment. Some HELs have fixed interest rates — meaning the interest remains the same over the length of your loan — while others have variable interest rates. With a variable loan, the loan’s interest rate can go up over time.
Depending on your situation, you might qualify for a loan with a longer repayment term, allowing you to make smaller payments each month. You could even qualify for an HEL with a 30-year repayment term.
Benefits of home equity loans
HELs are so appealing because of their low interest rates. Compared to other forms of debt, HELs can be much more affordable.
Jeff McGrath, a branch manager with Crown Mortgage Company, said there are other perks, too.
“Under current tax laws — subject to change, obviously — the interest on home equity loans is, under most circumstances, tax deductible,” he said.
According to the IRS, federal tax law allows you to deduct the interest you paid on a home equity loan. However, the loan cannot exceed $100,000. The HEL tax deduction can be affected by other factors, such as your income bracket, so it’s a good idea to consult with a tax professional before submitting your tax return.
Smart ways to use a home equity loan
Although HELs have several benefits, taking out a loan in any form is a big decision. An HEL does have risks, so it shouldn’t be used for any big purchase. However, if used carefully, applying for an HEL can be a useful option in the following situations:
1. Debt consolidation
If you have credit card debt, an HEL can help you save money over time.
“[Low interest rates] make home equity loans a smart choice for debt consolidation,” said McGrath. “This is especially true when consolidating credit card debts with very high interest rates.”
The Federal Reserve reports that the average interest rate for credit cards is 13.08%. If you had a $20,000 credit card balance with the average interest rate and took 10 years to pay it off, you’d pay back $36,000 in total. That’s nearly double what you originally borrowed.
By contrast, if you took out an HEL with a 10-year term at 4.43% interest and used it to pay off your debt, you’d pay back just $24,840. You’d save over $11,000 by consolidating your debt with your home’s equity.
2. Creating a safety net
If you experience a financial hardship, you can strategically use an HEL to get through a difficult time. Because your home is the collateral, you can take out an HEL even when facing an emergency.
“Another sensible use for setting up a home equity loan is simply to have a ‘safety net’ in the event of a real financial emergency, such as a job loss,” said McGrath. “For this use, the money is there to use when you hit a tight spot only, and then [should be] repaid quickly.”
An HEL can help you stay current on your bills while you’re job searching. Once you’re back on your feet, you can accelerate your repayment and eliminate the loan.
3. Financing a necessary expense
If you have an expensive and necessary purchase coming up, an HEL can be a useful tool. However, the key word is “necessary.” An HEL shouldn’t be used for something like a vacation — it’s too much of a risk.
Instead, HELs are best used for things you have to have right now, even if you don’t have the money saved.
For example, if a storm damaged your roof, you need to fix the roof as soon as possible to prevent further damage. If you don’t have the money saved, an HEL would allow you to fix your home at a lower interest rate than a credit card or personal loan.
Dangers of home equity loans
The reason HELs need to be used so carefully is because the risks are serious. Here’s what you risk if you take out an HEL.
1. You could lose your home
With an HEL, your house is your collateral. If things go wrong, you could end up losing it.
“If you stop making your minimum required payments on the loan, the bank can and will foreclose and you will likely lose your home,” said McGrath.
2. Your home’s value could decline
There’s no guarantee that your home’s value will increase or even remain the same. If your home’s value significantly decreases, you could owe more on your mortgage than the house is worth.
In that situation, even if you sold the home, you’d still owe money on the mortgage and the HEL, which can be financially crippling.
3. You might get deeper into debt
Although HELs are often a more cost-effective choice than other forms of debt, they are still debt.
“[It’s dangerous] when you haven’t first established a plan for how and when you will use that loan to improve your overall financial position,” said McGrath.
Without understanding how you got into debt in the first place and developing a repayment strategy, you could rack up more debt with an HEL on top of your other accounts. Instead, prepare ahead of time and come up with a budget, change your spending habits, and develop a loan repayment plan to stay on top of your finances.
Getting a loan
If you’re looking for a low-interest way to consolidate debt or finance a large expense, HELs can be a wise choice. However, make sure you know the risks involved and have a plan in place to manage your debt. Otherwise, you could end up losing your home.
If a home equity loan sounds too risky for you but you still need a loan, research your unsecured personal loan options.
Interested in a personal loan?Here are the top personal loan lenders of 2018!
|Lender||APR Range||Loan Amount|
|1 Includes AutoPay discount. Important Disclosures for SoFi.
2 Includes AutoPay discount. Important Disclosures for Payoff.
3 Important Disclosures for FreedomPlus.
4 Important Disclosures for Citizens Bank.
Citizens Bank Disclosures
5 Important Disclosures for LendingPoint.
6 Important Disclosures for LendingClub.
All loans made by WebBank, Member FDIC. Your actual rate depends upon credit score, loan amount, loan term, and credit usage & history. The APR ranges from 6.16% to 35.89%. For example, you could receive a loan of $6,000 with an interest rate of 7.99% and a 5.00% origination fee of $300 for an APR of 11.51%. In this example, you will receive $5,700 and will make 36 monthly payments of $187.99. The total amount repayable will be $6,767.64. Your APR will be determined based on your credit at time of application. The origination fee ranges from 1% to 6% and the average origination fee is 5.49% as of Q1 2017. There is no down payment and there is never a prepayment penalty. Closing of your loan is contingent upon your agreement of all the required agreements and disclosures on the www.lendingclub.com website. All loans via LendingClub have a minimum repayment term of 36 months or longer.
7 Important Disclosures for Earnest.
8 Important Disclosures for Avant.
* The actual rate and loan amount that a customer qualifies for may vary based on credit determination and other factors. Funds are generally deposited via ACH for delivery next business day if approved by 4:30pm CT Monday-Friday. Avant branded credit products are issued by WebBank, member FDIC.
** Example: A $5,700 loan with an administration fee of 4.75% and an amount financed of $5,429.25, repayable in 36 monthly installments, would have an APR of 29.95% and monthly payments of $230.33
* Important Disclosures for Upgrade Bank.
Upgrade Bank Disclosures
** Accept your loan offer and your funds will be sent to your bank via ACH within one (1) business day of clearing necessary verifications. Availability of the funds is dependent on how quickly your bank processes this transaction. From the time of approval, funds should be available within four (4) business days.
|7.73% – 29.99%||$1,000 - $50,000||Visit Upstart|
|5.81% – 15.37%1||$5,000 - $100,000||Visit SoFi|
|6.87% – 35.97%*||$1,000 - $50,000||Visit Upgrade|
|8.00% – 25.00%2||$5,000 - $35,000||Visit Payoff|
|4.99% – 29.99%3||$10,000 - $35,000||Visit FreedomPlus|
|5.99% – 18.99%4||$5,000 - $50,000||Visit Citizens|
|15.49% – 34.49%5||$2,000 - $25,000||Visit LendingPoint|
|6.16% – 35.89%6||$1,000 - $40,000||Visit LendingClub|
|5.49% – 18.24%7||$5,000 - $75,000||Visit Earnest|
|9.95% – 35.99%8||$2,000 - $35,000||Visit Avant|