Home equity loans are often promoted by banks and other financial institutions as a great solution to your short-term financial problems. It seems so simple — you use the value of your home to quickly get money that you can use for whatever it is you’re wanting to do with it. Travel? Paying off other debts? Home improvements? You name it, a home equity loan is pitched as the solution. This is particularly true at the current moment when home equity loan interest rates are at record lows, but before you fill your coffers with a home equity loan, consider the drawbacks and questions you need to ask yourself.
A home equity loan is not devoid of risk
Home equity loans are often presented as creating minimal risk for the person taking out the loan. You simply sign on the dotted line, get a big pile of cash to do whatever it is you’re intending to do, and then you pay it off with a series of relatively small payments over the coming years.
The problem with this picture is that not only is it a secured loan with collateral, but you’re also adding another monthly bill to the pile. Having collateral on a loan means that if you don’t pay the bills, you lose whatever the collateral is. In the case of a home equity loan, your collateral is your home. If you don’t pay the home equity loan, you lose your house. The bank takes it, sells your home to pay off the home equity loan and the mortgage on it, and keeps any remaining equity. In taking on that debt, you’re adding another monthly bill to your financial obligations for the foreseeable future. This means that you have to maintain a higher level of income in order to be able to continue to pay your bills, meaning that it becomes even more imperative that you keep your job and maintain personal financial stability.
On the other hand, a home equity loan is an easy way to consolidate credit card debt, student loan debt or personal loan debt. You might cut the interest rate, sure, but in a situation where you’re struggling to keep the bills paid, you suddenly put your house at risk when it wasn’t at risk before. If you’re struggling to repay non-collateralized debt, rather than getting a home equity loan, talk to your lender. See if you can work out a consolidation or an alternative payment plan. You might find ways to handle your financial difficulties without putting your home at further risk.
[Read: Best Home Equity Loan Rates for 2020]
Do you truly need a home equity loan?
While you’re considering the challenges of paying back the money you’re borrowing, also consider what you’re using that money for.
First of all, ask yourself if this purchase can wait. Is there any reason that you can’t wait a year for this expense until the economic situation is more certain? Waiting a year or two gives you more time to build equity in your home as well, as you’ll pay off more of the mortgage and the value of your home rises at the same time. For example, many people want to borrow money for a home improvement project, which is a reasonable decision in ordinary times, but if it’s not an emergency, it may be prudent to wait.
Next ask yourself if this purchase is really necessary. Do you really need to do this thing at all? Since you’re borrowing a lot of money for this, is this expenditure really something that’s in line with the big goals of your life, or is it just something that you really want right now? Another advantage of waiting is that it gives you time to reflect on whether the purchase is necessary at all.
Finally, if it is really necessary and urgent, is borrowing money via a home equity loan the best way to make it happen? Are there other avenues to consider that will help you achieve the goal you have in mind? Step back from the home equity loan decision for a moment and think about the broader problem you’re trying to solve. Are there ways of doing it that don’t involve additional collateral on your home?
For many people considering a home equity loan, honest and thoughtful answers to those questions will convince them to seek out other options.
[Related: Best Home Improvement Loans for 2020]
You might not have as much equity as you believe
The equity in your home is the current value of your home minus how much you still owe on your mortgage. If your home is worth $200,000 and you owe $120,000 on your mortgage, then you have $80,000 in equity in your home. A home equity loan borrows against that $80,000.
What’s the problem, then? For starters, your home might not be worth as much as you think it is. The lender will assess the current value of your home and use that as a basis to determine how much they can lend you. The problem, of course, is that as we enter a period of very high economic uncertainty, home prices are at risk of falling and banks are going to be conservative in terms of their estimate of your home value.
In that example above, the bank may estimate that your home’s actual value is only $180,000, so your home equity loan would only net you $60,000.
There’s also the underlying issue of your loan-to-value ratio. If you’re taking out a home equity loan that will cause the total debt on your home to approach 100%, you’re likely to get a worse interest rate on that loan, simply because the loan is a bigger risk for the bank. A lender less likely to get any money out of this if you were to default quickly. In a situation where home values aren’t rising much or if your home value has declined, the loan-to-value ratio might be worse than you expect, causing you to get a worse interest rate on your home equity loan. This is yet another reason why patience is on your side.
[More: Home Equity Line of Credit vs Personal Loan]
Tips for getting a home equity loan
Even after considering all of these points, there may be situations where getting a home equity loan is the right call. Here are some tips if you’re planning on moving forward with the loan.
- Take a look at your credit report and make sure there are no errors. Your credit report is one of the first things a lender will look at when it decides whether to lend to you or not. Before you go in to ask for a home equity loan, make sure your credit report is accurate by going to com. You should also make sure that you take care of other simple things that will improve your credit score, like paying down your credit card debts.
- Start with your current mortgage lender but shop around. The first place to look into a home equity loan is with your current lender, who will already have your information on file and will thus make the process much easier. They’re also much more likely to offer you a competitive rate. Still, it doesn’t hurt to shop around.
- Consider other methods of borrowing money. Don’t just limit yourself to the idea of a home equity loan. Look into the possibility of a personal loan for smaller amounts. If you have good credit, the interest rate might be higher, but there’s no collateral. You might also want to consider a refinance of your home loan, particularly if interest rates are very low. By lowering your interest rate on your mortgage, you may be able to borrow more without increasing your monthly payment.
Too long, didn’t read?
Remember that home equity loans should only be considered when you’re absolutely sure that borrowing money is the right option for you. Since your house is on the line, you stand to risk a lot more than you would with an unsecured loan. Make sure the purpose is right and the timing is right before you borrow against your home.
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Last updated August 10, 2020 – Updated recommendations on home equity loans for the 2020 pandemic recession.
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