If you need to borrow money, home equity loans and HELOCs offer a lot of advantages compared to other types of loans. But there are some downsides as well. Here are some of the main ones to keep in mind.
Things to like about home equity loans
First, the advantages of a home equity loan or HELOC:
• Home equity loan interest rates tend to be lower than rates on other types of consumer debt. That's because they're secured loans, where the loan is backed by the equity in your home. Unsecured loans like credit cards and personal loans are backed by nothing but the lender's faith that you'll repay your debts – and that's a riskier proposition, and means you pay a higher interest rate as a result.
• There are no restrictions on how you use the money. While certain types of loans require that you justify your plans for the money - think of putting together a business plan for a business loan, for example – a home equity loan can be spent however you wish.
• Interest on home equity loans is generally tax-deductible, similar to your primary mortgage. However, there are tighter limits on how much you can deduct if you use the funds you borrow for any other purpose than to buy, build or improve a home. See the tax section below.
• Qualifying for a home equity loan or line of credit can be easier than obtaining other loans if you have flawed credit. Because the main qualification is how much home equity you have to back the loan, lenders are often more forgiving of credit flaws than they would be if you were seeking to borrow a similar amount through an unsecured loan.
• Repayment terms are often longer than for other types of loans. Standard home equity loans typically allow 5-15 years to repay, while HELOCs allow a 5-10 year draw, followed by a repayment period of up to 20 years.
• A HELOC is one of the few ways you can still get an interest-only home loan and not have to begin repaying the principle for 5-10 years. Remember, a HELOC is usually interest-only during the draw period, so even if you max out your line of credit all at once, you still only have to keep up with the interest payments for as long as the draw period lasts. This can be helpful if you need to minimize your expenditures for awhile until your cash flow improves.
Things to watch out for
While there's a lot to like about home equity loans, there are some potential pitfalls as well. Keep the following things in mind when dealing with a home equity loan or HELOC.
• Because your home equity serves as collateral for the loan, you could lose your home to foreclosure if you fail to keep up your payments and default.
• Because HELOC rates are adjustable during the draw period, your monthly payments could end up being higher than you expected if rates rise before you reach the repayment phase.
• You might have to take out a larger loan than you need. Lenders have minimum amounts for both HELOCs and standard home equity loans, which vary from lender to lender. While some will approve a home equity loan or line of credit for as little as $5,000-$10,000, minimums of $15,000-$25,000 are more common. The lenders with the higher minimums may also be the ones offering the best home equity loan rates and terms, so there may be a real temptation to borrow more than you need.
• Home equity loans can make it easy to overspend. If you only need to borrow $7,000 for a home improvement project but took out a home equity loan or line of credit for $15,000, there can be a real temptation to start dipping into the extra $8,000 for odds and ends. Before you know it, you've blown through the whole thing.
• Repetition is another risk. After they've done one home equity loan, some people fall into the habit of using their homes as piggy banks, tapping into their equity repeatedly for nonessential spending.
• Home equity loan fixed-rates are higher than what you'd pay for a fixed-rate primary mortgage. So you may be better off with a cash-out refinance, particularly if you can also reduce your primary mortgage rate in the process. A cash-out refinance may also be a better option if you need to borrow a large sum of money and would
• Depending on where you live, you may need to pay a mortgage recording tax when you take out a home equity loan or HELOC. Such taxes are based on your loan amount, so the more you borrow, the more you have to pay.
Used properly, a home equity loan or HELOC can be a useful financial tool. But like any powerful tool, it can hurt you if you're not careful. Know what you're getting into and proceed appropriately.