Advantages and Disadvantages

Pros and Cons of Taking Out Home Equity

Pros of Home Equity Loans

Home equity loans are currently all the rage. More and more Americans turns to home equity for financial needs because home equity loans have the following advantages.

Relatively cheap and easy to get: You can convert your already existing equity into cash quickly and with relatively little cost upfront. Because competition among banks and financial companies is so fierce – Home equity is the bank’s hottest product these days -- many are even waiving up-front fees.
Low interest rates: Though home equity products usually have a higher interest rate than first mortgages, their rates are lower than those of your credit cards or any other kinds of loans.
Convenience: It can be used for a wide range of things -- from paying for debts, home improvements, tuition, medical costs, cars, boats or a vacation. It can also provide ready access to money in emergencies.
Flexible terms: You can pay back only the interest on the loan for several years or until it matures. Banks are very flexible on this. However, you need to be aware of its “built-in booby trap” that some day could explode in your face; you have to pay it off in full when it’s time.
Tax advantages: While tax changes in 1986 eliminated deductions for most consumer purchases, home equity loans are still a way to buy goods and get a deduction; you may deduct up to $100,000 worth of interest payments on your federal tax return. So it often makes sense to move loans whose interest is not tax deductible—for example, car loans or credit-card interest —over to a tax-deductible home equity loan. Ask your tax consultant for more details.

Cons of Home Equity Loans

Just because home equity loans are popular doesn’t mean they are always a good idea. Consider the following disadvantages of a home equity loan.

Risk of foreclosure: The number one risk is that you’re putting your house on the line. What would happen if you lose your job or encounter other hardships such as serious medical problems? Should you fail to make your payments, you could actually lose your home to the lender. In fact, if you use home equity loan proceeds to buy a car and don’t make the payments, you may lose your house instead of your car. Home equity loans may not be a good idea unless you are 100 percent confident that you can make the payments.
Upfront-fees: Lenders charge all sorts of fees before granting you a home equity loan. When you compare the interest savings, add the fees and make sure that it is still the smart choice to get a home equity loan. If your need for fund is short-term, a higher interest rate for a consumer loan from a bank might be less expensive than the fees involved in equity financing.
Expensive in the long run: Even though the interest rate is less and the monthly payments are low, most of the borrowers end up paying more over the long run because the payments are stretched out over a longer period. In addition, if you take out a home equity line of credit, it is a revolving account and the interest adds up on the total of principal and interest you owe, which makes it more expensive.
Possible change in the loan term: Banks monitor your payment habits and if they see a change for the worse, they can reduce or freeze your credit line or call for full payment of the loan.
Reduction in your equity: Home equity is a time-proven way to accumulate wealth and provide a sense of security. A home equity loan reduces or eliminates your equity in your home. If you didn’t use the equity in your home as a source of funds, you would have that much more cash available from selling your home, for your retirement.
Increase in debts: Because home equity loans give you relatively easy access to cash, you might find yourself borrow money more freely. In fact, many borrowers who don’t discipline their spending habits get deeper indebted after once paying off their other debts through home equity loans.

Use Your Home Equity Loan Wisely

If you need to borrow money, a home equity loan, with lower monthly payments, tax-deductible interest, and easy access, can be one of the most useful sources of credit. At the same time, a home equity loan requires you to use your home as collateral for the loan. This may put your home at risk if you are late or cannot make your monthly payments.

Such a loan can be a risky spending tool for a younger homeowner, who are not established in his career and has less experience managing money. It probably won’t be a good idea for older people who are living on a fixed income, close to retirement. On the other hand, if you have a secure job and stick to a budget, this loan can be a smart way to pay for college, credit card debt, medical bills, or other necessities. If used wisely for debt consolidation, this loan can also brighten your overall financial status and improve your credit rating.

To use home equity loan to your advantage:

Never overextend yourself.
Make a hundred percent sure that you can make the payments before applying for the loan.
Carefully compare different loan options and decide which loan product best suits your financial goal.
Avoid the increasingly popular “interest only” payment option and get your debts paid off as quickly as possible.
Use the money only for its intended purpose and do not take any more debts; forgo using credit cards and spend within your budget.

Related Articles: