The Advantages and Disadvantages of Home Equity Loans

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Owning a home means more than having a long-term investment — it also means being able to access your home equity for big expenses. Tapping into your home equity is can be useful for getting access to quick cash to pay for major home renovations, cover emergency expenses, or consolidate debt.

Your current mortgage balance and home’s value determine the size of your home equity loan. In some cases, lenders may allow you to borrow up to 80% of your home’s value, depending on your credit history. 

While a home equity loan can sound like a great idea, there are some caveats to keep in mind. Before you think of getting a home equity loan, it is important to consider some of the advantages and disadvantages that this financing option offers. 

The Pros of Home Equity Loans

Here are some benefits of home equity loans: 

They Are Affordable

The interest rates on a home equity loan are significantly lower than other lending options such as credit cards. For instance, credit card interest rates are astronomical, averaging between 14.58% for existing accounts and 17.87% for new accounts. This makes it impossible to ever pay back your balance with the minimum payments, which means you may end up struggling to pay off your credit cards. In contrast, interest rates for home equity loans average closer to 5% or 6% if you have good credit.

They Help You Gain Liquidity

If you need liquid assets to pay for a major expense, then a home equity loan can get you that cash. Now you can more easily finance your education, start a business, or consolidate your debt. You may also need more liquidity to pay for emergency expenses, and a home equity loan can help with that.

They May Come With a Tax Deduction

If you have a home equity loan, you may be eligible for a tax deduction. However, you can only deduct home equity loan interest on your taxes if you use the loan to build, purchase, or renovate your home. You cannot deduct interest if you use the loan on non-property related expenses, such as consolidating debt or purchasing other assets. Talk to a certified tax professional in your state to find out the tax implications of a home equity loan for you

They Are Relatively Easy To Obtain

Acquiring a home equity loan is rather easy for many people because it is a secured type of loan. To see if you qualify, the lender simply calculates your home value and your creditworthiness to determine the general loan-to-value amount. This means if you don’t have a lot of debt and have a strong credit score and a steady income, then you’re a good contender for a home equity loan.

They Are Convenient

Besides the low-interest rates, if you’re using your home equity loan to repay your credit cards, you’ll have the advantage of consolidating all your debts into only one payment plan. This can bring much-needed relief and give you ample time to organize your financial strategy since your debts will be on a single payment plan.

The Cons of Home Equity Loans

There are some downsides to home equity loans as well, including: 

You Can Only Borrow a Lump Sum Amount

With a home equity loan, you are only allowed to borrow a lump sum of money rather than small amounts as you need them, making it less responsive to your needs. It’s important to borrow carefully and not take out too much; otherwise, you might spend more than you’d originally intended, and you’ll be paying more interest on money you didn’t need. 

You Cannot Borrow With a Poor Credit Score

Like with any other loan, lenders want to know your ability to repay the funds. The first thing they check is your loan repayment history. To qualify for a home equity loan, you need to have a credit score of higher than 680, with a debt-to-income (DTI) ratio of less than 50%. Your debt-to-income ratio compares your monthly debt payments to your monthly gross income. Typically, a DTI of 43% is the highest ratio you can have and still qualify for a mortgage.

It is also important to note that all lenders have their own credit score requirements. So, if your credit score is low, you’re less likely to secure a home equity loan. 

You Use Your Home As a Collateral

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Although some financial institutions may be willing to work with you to restructure your home equity agreement in case of unforeseen difficulties with repayment, be prepared for the worst. If you are unable to repay the loan, the lender may seize your home to repay the money owed. This fact makes it hard for some people to consider taking out a home equity loan. 

They Have Higher Rates Than Actual Mortgage Rates

Despite having lower interest rates than many lending options in the market, equity loan interest rates are a bit higher than introductory mortgage rates.

They Add a Monthly Payment

With a home equity loan, you will have an additional monthly payment to contend with on top of your mortgage and other regular bills. If you’re already stretched thin financially, make sure you can afford the extra monthly costs.

How To Secure a Home Equity Loan

Here are the steps you can take to use your home’s equity:

  1. Research your options. You should approach several lenders and compare their costs, especially interest rates. You can use banks and credit unions, loan originators, or brokers as resources to get interest rate estimates.
  2. Calculate your equity and debt-to-income ratio. To get a DTI, the lender will divide your monthly bills by your gross monthly income. Your equity must be at least 15%, and the amount of equity you have determines how much you can borrow. You must also have a steady source of income. The lender will evaluate your most recent earnings to see if you can repay the loan. A reliable income also lowers your debt-to-income ratio, which should not exceed 36%. A low ratio is an indicator that you can repay the loan in time. However, expenses such as utilities, taxes, and groceries are not included as part of the bills. 
  3. Have your credit score checked. After you complete the application, your lender will check your borrowing history from the credit bureaus to confirm your credit score. A credit score of above 680 and a debt-to-income ratio of less than 50% greatly increase your chances of getting the loan. Some lenders might be willing to allow lower scores, albeit at higher interest rates.
  4. Get your home appraised. The lender may also require an appraisal to help establish a fair market value of your property and the amount of equity you can access. This process usually takes weeks.

If you’re looking for a way to unlock your home equity with more flexible qualification criteria, you may be interested in Point‘s Home Equity Investment (HEI). You may be able to qualify for an HEI even if you have a lower credit score or don’t have an ideal DTI. You receive a lump sum ranging from $35,000 to $350,000, and in exchange we share a portion of your future home appreciation. There are no monthly payments with an HEI. Instead, you repay with a lump sum when you sell, refinance, or use another source of funds any time within the 30-year term. 

For more information about our products and services, please don’t hesitate to contact us. We would be glad to help.

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