FG Trade/GettyImages, Illustration: Hunter Newton/Bankrate
When you need funds, there are two main types to choose from: A secured loan requires collateral to back (secure) your debt An unsecured loan doesn’t require collateral A home equity loan falls into the former category and is secured by your home.
A home is something you put a lot at risk in. Is a mortgage a good idea? Let’s weigh the pros and cons.
What is a Home Equity Loan?
A home equity loan is a type of second mortgage that uses a portion of the equity in your home — the difference between the value of your home and the remaining balance on your mortgage — to obtain a set amount of money. You can borrow a set amount of money based on the size of this equity, or complete ownership interest.
Home equity loans come with a fixed interest rate and are paid off just like a mortgage, meaning you make monthly payments over a set period of time, like 15, 20, or even 30 years. You can use the funds for any purpose, including paying for education expenses, renovating your home, or managing medical expenses.
Pros and Cons of Home Loans
“Since mortgages offer a fixed interest rate and the stability of monthly payments, they can be a great choice for larger expenses like home improvements. But because a mortgage is secured by your home, defaulting on payments can lead to foreclosure,” says Linda Bell, senior mortgage writer at Bankrate. “It’s important to balance the benefits with the commitments.”
Benefits of a home loan
- Predictable Interest Rates: Home equity loans have a fixed interest rate for the entire term of the loan, so your interest rate won’t change regardless of market fluctuations. You won’t be hit with sudden interest rate hikes because you know exactly how much you’ll be paying to get your loan.
- Consistent monthly payments: Because your interest rate is fixed, your monthly mortgage payment will also remain constant for the life of your loan. This constancy makes it much easier to plan and budget your monthly expenses.
- Relatively low interest rates: Mortgages typically have lower interest rates than personal loans or credit cards. “Although there are processing and other fees, it’s still a cheaper option than an unsecured loan,” says Laura Sterling, vice president of marketing at Georgia’s Own Credit Union in Alpharetta, Ga. Using real estate as collateral also reduces the risk of the loan to the bank or mortgage company, which means lower fees.
- Extending repayment period: The repayment term for a mortgage can be as long as 30 years. With a long repayment term and relatively low interest rates, monthly payments can be lower.
- Greater borrowing potential: Depending on the size of your property, a mortgage can give you a larger loan amount than a credit card or personal loan can give you — a five- or six-figure amount that you can use for home improvements, paying off high-interest debt, emergency repairs, and more.
- Tax Benefits: If you use your loan funds to make significant renovations or repairs to your home, your mortgage interest is tax deductible (if you itemize deductions on your tax return), which can lead to additional savings and potentially a lower overall tax burden.
Disadvantages of home loans
- Chances of losing your home: Simply put, if you don’t pay your loan back, the lender can foreclose, which can not only evict you and any other tenants, but can also do lasting damage to your credit and make it more difficult to get a mortgage or other type of financing for a while.
- Minimum capital requirements: Typically, you can’t get a mortgage unless you have at least 20 percent equity (some lenders allow 15 percent), meaning you own one-fifth of the home outright. If you’re buying a new home and haven’t made a big down payment, you’ll likely have to wait a while before you can tap into your equity.
- Closing costs: Home equity loans come with costs, such as origination fees, appraisal fees, etc. Closing costs are typically around 1% of the total loan amount, compared to 2% to 5% for a primary mortgage.
- Longer funding period: While the process is less onerous than a traditional mortgage, the process of applying for a mortgage and receiving funds is longer than the personal loan process, often taking more than a month. If you need cash fast, it’s not a good option.
- Debt gets worse: A mortgage dilutes the value of your primary asset – your home – by turning something you own (your equity) into a liability that you owe.
- Liability Risk: If your local residential real estate market drops significantly, your home’s value could fall and you could find yourself “underwater,” where your mortgage balance exceeds the value of your property. “If your home’s value goes down, you could end up owing more on it than your home is worth, which could make it harder to sell,” Sterling says.
A home equity loan offers the stability of a fixed interest rate and monthly payments. However, your home is used as collateral for the loan. It’s important to balance the benefits with the responsibilities.
— Linda Bell, Senior Writer at Bankrate
Do all mortgages have fees?
Most lenders charge fees for mortgages, so expect to have to pay the following costs:
- commission: The amount varies depending on the lender and the amount borrowed.
- Appraisal fee: This typically costs between $300 and $800.
- Credit check fee: Lenders will charge a small fee to obtain your credit reports, with a minimum of $10 and a maximum of $100 per credit report.
- Document or application fee: According to the Homebuying Institute, the average county registration fee at closing is $125.
- Title Fee: Because the home serves as collateral for the mortgage, the lender will perform a title search of the property to see if there are any liens or claims already existing on the property. This fee ranges from $75 to $200 depending on the location, but can go up to $450.
- Discount points: Some lenders allow you to pay upfront fees called “points” to lower your interest rate – each point is one percent of the amount borrowed.
“Compare-shopping lenders is a smart move to ensure you get the best terms when it comes to fees,” says Bell. “Starting with your current lender can be beneficial, as they may offer you a special rate for being a loyal customer. And don’t be afraid to negotiate; lenders are often flexible, and asking for lower fees or better terms could save you money in the long run.”
Home Equity Loans vs. HELOCs: What’s the Difference?
A home equity loan and a HELOC (short for Home Equity Line of Credit) are both loans that you can take out against your home, meaning the property serves as collateral for the loan, but they work differently.
When you take out a home equity loan, you receive a lump sum of funds. A HELOC, on the other hand, is a revolving line of credit, like a credit card, that you can draw on when you need it. Home equity loans have fixed interest rates, while HELOC interest rates usually fluctuate.
With a home equity loan, your monthly payments remain the same for the life of the loan, which is usually 10 to 30 years. In contrast, a HELOC has an initial 5-10 year draw period during which you can withdraw money if you want, and optionally pay back the interest only. Then you enter a repayment period, which usually lasts 10-20 years, during which you must pay back the amount you borrowed plus interest. You can no longer withdraw funds.
Alternatives to mortgages
Qualifying for a home equity loan can be difficult. If you don’t think you can get a home equity loan or you simply feel like it’s not your best choice, consider these other options:
- Cash-out refinancing: A cash-out refinance is when you replace your existing mortgage with a new, higher-value loan. You receive the difference (based on your home equity) in cash. The main advantage is that you have one monthly payment instead of two. The disadvantage is that if you’re currently paying a low interest rate, it may not make sense to take out a new loan, especially if interest rates have risen since then.
- Personal Loans: Personal loans don’t require collateral, so your home and other assets are safe. However, you usually can’t borrow as much money with a personal loan, you have to pay it back faster, and the interest rate is definitely higher than with a mortgage.
- Reverse Mortgage: For people age 62 and older (55 and older for some products): A mortgage with monthly payments made by the lender. Unlike a HELOC or home equity loan, the money withdrawn does not have to be repaid in monthly installments. However, if the borrower dies, moves out permanently, or sells the home, the principal and interest must be repaid.
