Home equity hit a record high of $9.9 trillion at the end of 2021. If you’re one of the many Americans who are currently sitting on an ocean of untapped home equity, you’re likely getting advertisements encouraging you to take out a home equity loan. Is one a good idea for you?
Key Takeaways
- A home equity loan allows you to borrow a lump sum of money against your home’s equity and pay it back over time with fixed monthly payments.
- A home equity loan is a good idea when used to increase your home’s value.
- 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 one-time lump sum and pay it back at a fixed interest rate with equal monthly payments over an agreed-upon time frame. 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 you have in your home as collateral for the loan.
Home equity loans, home equity lines of credit (HELOCs), reverse mortgages, and cash-out refinances are all ways to get cash by borrowing against your home. By using your home’s equity in this way, you are taking on two main risks:
- If you can’t afford to pay your loan(s) back, you could lose your home in a foreclosure.
- If your home’s value decreases, you could become underwater on your loan(s). In that case, you won’t be able to sell your home without taking a financial loss.
When a Home Equity Loan Is a Good Idea
A home equity loan can be a good idea when used to fund a project that will directly increase your home’s equity. Tapping into your home’s equity through a loan decreases the equity you have in your home until the loan is paid back. Using the loan to invest in a project that will increase your home’s value can help mitigate the risk of the loan.
A home equity loan is a comparatively good idea when considering a reverse mortgage as they have much lower fees, but they still should be used only when financing a project that will increase your home’s value.
Using a home equity loan to consolidate high-interest debt can be a good idea as long as you have the discipline and changed circumstances to pay off the home equity loan on time. Make sure that you are addressing any underlying habits that could have caused the high balance of debt, like overspending simultaneously, so you don’t end up stuck in a debt spiral.
When a Home Equity Loan Is a Bad Idea
In general, a home equity loan is a bad idea when it is used for anything other than something that will directly increase your home’s value. A home equity loan is a particularly bad idea when used frivolously. Don’t use a home equity loan to fund a lifestyle that your income can’t sustain. If you can’t afford luxury dinners, cars, and vacations on your income, don’t erode your home’s equity to temporarily live that lifestyle.
Is a home equity loan or a home equity line of credit (HELOC) a better idea?
Both a home equity loan and a home equity line of credit (HELOC) borrow against your home’s equity and carry the same risks. A HELOC has a variable interest rate, whereas a home equity loan almost always has a fixed interest rate. When interest rates are rising, it’s better to take out a home equity loan than to carry a high balance on a HELOC. A HELOC can be a better idea for flexibility, particularly for real estate investors who will draw down and pay off the HELOC repeatedly over the course of purchasing multiple properties.
Should you take out a home equity loan to get a tax deduction?
No, you should not 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 that secures the loan. Keep in mind that this only benefits you if you itemize your tax deductions. If you take the standard deduction, you’ll see no benefit to having a home equity loan for tax purposes.
Is a home equity loan a good hedge against job loss?
No. A home equity loan requires you to make repayments shortly after taking one out. Thus, tapping your home’s equity to get cash before a potential layoff has limited utility.
What can home equity loan proceeds be used for?
You can use your home equity loan proceeds on whatever you want. Nothing but your own common sense is technically stopping you from putting the whole thing on black at your local roulette table. This is why it’s vital to understand the risks and take out a home equity loan conscientiously.
The Bottom Line
Like many other loan products, a home equity loan can be a good idea in some circumstances and a terrible idea in others. Understand the risks and consider whether risking your home is worth whatever you’re taking out the loan for. In general, you should only consider a home equity loan for something that can increase your home’s value.