Personal Finance

Is a Home Equity Loan Right for You?

Home with a couple standing in front of it

Considering a home equity loan? Here are a few key questions to ask to help you decide if it's the appropriate option to fit your circumstances.

Home with a couple standing in front of it

Image source: Getty Images.

When you need to borrow money, there are a number of options worth considering -- each with their own pros and cons. For homeowners, one option to borrow is to obtain a home equity loan. Home equity loans can be used for any purpose, from remodeling your home to paying down debt, to taking a vacation. But, you're taking a risk when you borrow against the equity in your home, so you'll have to weigh the benefits and risks when deciding whether this type of loan is right for you. Not sure where to start? Read on for some key advice that will help you to decide if a home equity loan is right for you.

You need equity to get a home equity loan

Home equity loans can come from your original mortgage lender or from other lenders that allow you to borrow against your house. But, lenders will not give you a home equity loan unless you actually have equity in your home. Typically, the total amount you can borrow including your primary mortgage and your home equity loan is around 90% to 95% of the value of your home, at maximum. This is called your loan-to-value ratio. And, many lenders will be willing to lend you even less, with some even capping your total loan balance at 80% of what your home is worth.

You'll likely need a home appraisal to find out what your home's market value is so the bank can determine how much you're allowed to borrow. And, if you find your home isn't worth much more than you currently owe, a home equity loan won't be an option for you and you'll need to pursue other sources of funding.

Home equity loans can be more affordable than other kinds of financing

One of the biggest benefits associated with a home equity loan is that these loans often have a pretty low interest rate. Typically, the interest you pay on a home equity loan will be far below the interest rate on credit card debts, payday loans, and other high interest loans. The rate will likely even be lower than the interest rate on personal loans .

Not only is the interest rate affordable, but you may also be able to take a tax deduction for the interest you pay on a home equity loan as long as you use the loan funds to pay to buy, build, or substantially improve the home that you've borrowed against. If you can deduct interest, this further reduces the amount your loan costs you.

There are big risks to home equity loans

While a home equity loan is an affordable source of financing, it's also a risky one. The problem is, your home has to act as collateral to guarantee the loan. This gives the lender a legal interest in your home. If you aren't able to pay back your home equity loan, the lender could foreclose on your home. This means that whenever you take out a home equity loan, you take the risk of losing your house if something goes wrong.

Many other kinds of debt, such as credit card debt and most personal loans, are unsecured debt. There's no collateral guaranteeing them, so if you don't pay, a lender could sue you and perhaps garnish your wages or get a lien on your house -- but the lender wouldn't be able to force the sale of your home to get repaid. You need to be 100% sure you are going to be able to pay back a home equity loan before you decide to put your house on the line.

Getting a home equity loan can be costly

Obtaining a home equity loan can be more expensive than getting other types of financing.

It's usually free to sign up for a credit card, for example, unless the card has an annual fee. And, personal loans are often free or inexpensive to obtain if they don't have application or origination fees. But, with a home equity loan, you'll probably need to pay for an appraisal as well as paying other upfront fees to the lender. The appraisal alone could cost a few hundred dollars, and then you'll potentially also have an application fee, filing fees, document preparation fees, attorney fees, fees for a title search, and fees to obtain other required documents such a flood evaluation certificate if your lender requires one.

Having to pay a lot of money to get a loan can negate some of the savings that comes from the lower interest rate home equity loans provide. You'll need to look at the big picture when it comes to loan costs, including interest rates and fees when you decide if a home equity loan is the most affordable solution.

Is a home equity loan right for you?

If you're borrowing for something important and you're confident you can pay back the loan, a home equity loan may be right for you -- assuming you have enough equity in your home. But, you should make sure to understand the costs and the risks before you decide to go to the bank and take out a loan against your home.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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