Is a home equity loan a good idea?

Home equity reached an all-time high of $9.9 trillion at the end of 2021. If you’re one of the many Americans currently sitting on an ocean of untapped equity, you’re probably receiving advertisements encouraging you to take out a home equity loan. Is this a good idea for you?

Key points to remember

  • A home equity loan lets you borrow a lump sum of money against the equity in your home and pay it back over time with fixed monthly payments.
  • A home equity loan is a good idea when used to increase the value of your home.
  • A home equity loan is a bad idea when used to spend frivolously.

How home equity loans work

A home equity loan is a loan that allows you to take out a single lump sum and repay it at a fixed interest rate with equal monthly installments over an agreed period of time. Home equity loans offer lower interest rates than other forms of unsecured debt, such as credit cards and personal loans, because they use the equity in your home as collateral for the loan.

Home equity loans, home equity lines of credit (HELOCs), reverse mortgages, and cash refinances are all ways to get money by borrowing against your home. By using the equity in your home in this way, you are taking two main risks:

  • If you can’t afford to repay your loan(s), you could lose your home to foreclosure.
  • If the value of your home declines, you could find yourself under water on your loan(s). In this case, you will not be able to sell your house without incurring financial loss.

When a home equity loan is a good idea

A home equity loan can be a great idea when used to finance a project that will directly increase the equity in your home. Tapping into the equity in your home through a loan decreases the equity in your home until the loan is paid off. Using the loan to invest in a project that will increase the value of your home can help mitigate the risk of the loan.

A home equity loan is a relatively good idea when considering a reverse mortgage as they have much lower fees, but they should still only be used when financing a project that will increase the value of your home.

Using a home equity loan to consolidate high interest debt can be a good idea as long as you have the discipline and circumstances to pay off the home equity loan on time. Be sure to tackle any underlying habits that may have caused the high debt balance, such as overspending simultaneously, so you don’t get stuck in a spiral of debt.

When a home equity loan is a bad idea

In general, a home equity loan is a bad idea when used for anything other than something that will directly increase the value of your home. A home equity loan is an especially bad idea when used lightly. Don’t use a home equity loan to fund a lifestyle your income can’t support. If you can’t afford fancy dinners, cars, and vacations with your income, don’t erode your home equity to temporarily live that lifestyle.

Is a home equity loan or home equity line of credit (HELOC) a better idea?

A home equity loan and a home equity line of credit (HELOC) borrow against the equity in your home and carry the same risks. A HELOC has a variable interest rate, whereas a home loan almost always has a fixed interest rate. When interest rates rise, taking out a home equity loan is better than having a high balance on a HELOC. A HELOC can be a better flexible idea, especially for real estate investors who will draw and pay off the HELOC multiple times during the purchase of multiple properties.

Do you have to take out a mortgage to benefit from a tax deduction?

No, you shouldn’t take out a home equity loan just for the tax deduction. If you already have a home equity loan, you may be able to get a tax deduction for the interest portion of the loan as long as you use the loan proceeds to “buy, build, or substantially improve” the home securing the loan. Keep in mind that this only benefits you if you itemize your tax deductions. If you take the standard deduction, you won’t see any benefit to having a home equity loan for tax purposes.

Is a home equity loan good protection against job loss?

No. A home equity loan requires you to make repayments soon after taking out one. So, tapping into your home equity to get cash before a potential layoff has limited utility.

What can the proceeds of a home equity loan be used for?

You can use the proceeds from your home loan on whatever you want. Technically, nothing but your own common sense is stopping you from putting everything on black at your local roulette table. That’s why it’s essential to understand the risks and take out a home equity loan consciously.

The essential

Like many other loan products, a home equity loan can be a good idea in some circumstances and a bad idea in others. Understand the risks and ask yourself if risking your home is worth what you are taking out the loan for. In general, you should only consider a home equity loan for something that can increase the value of your home.

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