The Pros and Cons of Home Equity Loans

Elizabeth VanCamp

My husband and I recently purchased his grandparents’ house and we’re excited about adding our own touch to this family home. The house has so much nostalgia for my husband, and it has some really awesome features, like a brick fireplace and a deck that spans the entire length of the house.

Even with all the great features, we, like many new homeowners, have a list of home improvement projects we’d like to do. While most of the updates and improvements are cosmetic (here’s looking at you, Pepto-Bismol pink bedroom and baby blue bathtub), there are some really big projects that we’d like to take on too, like finishing the basement.

Upon looking into the cost of this project—basements cost an average of $40,000—we realized that we wouldn’t be able to afford to do it any time soon without taking out a loan. A home equity loan seemed like a logical choice, but we wanted to truly understand the pros and cons of this kind of loan so we could decide if borrowing against our home would be the right route for paying for a big home project like this.

What is a Home Equity Loan?

A home equity loan allows you to borrow equity against the value of your home to pay for things such as home improvement projects, college, or a vacation. Are you confused by what that means? I was too at first. Let me give you an example to make it a little clearer:

Let’s say you bought your home for $150,000 and it’s still valued at that amount, and you’ve paid $50,000 on your mortgage, leaving your balance at $100,000. Depending on your financial institution, you can apply for up to 85% of your home’s value. Since your home is still valued at $150,000, 85% would be $127,500. After subtracting what you still owe on the mortgage ($100,000), you would have $27,500 in equity to borrow.

HOME EQUITY LINE OF CREDIT

A HELOC is very similar to a home equity loan, but one of the main differences is how you draw the funds. With a HELOC, you use your equity as a line of credit, similar to a credit card. You pull from the equity you get approved for as needed, and your payment will change depending on the amount you’ve taken out.

Similar to a home equity loan, HELOCs use your home as collateral, so there’s a risk of losing your home if you don’t make your payments on time. Additionally, HELOCs have variable rates so although rates are typically pretty low, they could suddenly spike and leave you with uncertainty about how much your next month’s payment will be.

Something that really sounds the alarm for me is that because this loan isn’t a lump sum, if your credit score or the value of your home changes, your lender could potentially lower your limit or freeze your access to the line of credit altogether. If you’re not a fan of uncertainty (me either!), this could be stressful for you.

Before doing my research, I thought this option would be the better choice for when we’re ready to finish our basement because we wouldn’t be tempted to take all the equity our credit union offers us, and would just take what we need for the project. We have become very responsible with our credit card and feel some peace of mind knowing that credit is there in case we really need it. Since this kind of home equity loan works similarly, I thought it might be the right fit for keeping us accountable to our home’s equity. However, some of the risks a HELOC presents are making me rethink this option.

Many Americans have no problem utilizing this kind of loan, however. With HELOCs being a good compromise between a big lump sum of money and racking up credit card debt, it’s no wonder that according to Trans Union, around 10 million people are expected to utilize them between 2018-2022. Talk to your financial institution about whether a HELOC would be the right fit for your next big project or purchase, like that reliable car you’ve been wanting to buy.

HOME IMPROVEMENT LOAN

A home improvement loan is another choice you have when trying to complete a project around your house. Like the home equity loan, home improvement loans have low rates and fixed payments, and you’ll receive the funds in a lump sum.

There are some key differences between home equity and home improvement loans. While you might be eligible to take out a very large amount through a home equity loan, many financial institutions have lower caps on home improvement loans, such as $7,500. Also, some banks and credit unions require you to use a home improvement loan for actual home improvement projects, so you don’t have the same kind of freedom for how to spend the loan.

I’ve taken out a home improvement loan before and had a great experience with it. I was able to replace my leaky roof and install a wooden privacy fence for my dogs, and I wasn’t riddled with sudden, high interest debt. Because the loan wasn’t very large, the payments were manageable and I even paid off the balance earlier than expected.

REFINANCE YOUR HOME

A third alternative to a home equity loan would be refinancing your home for more than its value so you can remodel or do repairs. IHMVCU offers a Fannie Mae HomeStyle Renovation Mortgage for those who want to purchase a home that needs work or those who already own a home that needs some major upgrades.

Buyers (or homeowners who are refinancing) can bundle the cost of the home with the cost of repairs and remodeling so they have the convenience of only one mortgage payment. This type of loan can help you stay in a home you love that just needs a little extra, well, love. Or it can help you afford that home that’s in the perfect location but needs some serious TLC.

Some things to be aware of with the Fannie Mae HomeStyle Renovation Mortgage are:

• Repairs and other home improvement projects need to be completed within 12 months of the loan origination

• The closing process for Fannie Mae HomeStyle Renovation Mortgages can take longer than traditional mortgages

• Not all lenders offer this kind of loan

This kind of loan is a great concept and could be the perfect fit for you and your home improvement needs, but make sure you fully understand how it all works before applying.

The Pros

There are lots of good reasons to consider a home equity loan. They often have low, fixed interest rates, and no annual fee, plus you’ll have fixed payments and the loan’s interest could be tax deductible (but you’ll need to talk to your tax advisor about that). One of the biggest perks? You can use the lump sum for whatever you want, not just home improvement projects.

This kind of loan is enticing for me because we could easily apply for one and have enough equity (due to the market value of our home currently being so high) to complete our basement right now instead of 4-5 years down the road. But, if you’re like me, and are very cautious when something sounds just a little too good, read on to the cons of home equity loans.

The Cons

I didn’t own a home during the 2008 housing crisis but I remember the negative ripple effect it had throughout the country on homeowners and the economy. It scares me to borrow against my house, essentially taking out a second mortgage. I wouldn’t apply for a mortgage for $40,000 more than I needed, why would I take out that large of a loan now?

It turns out I’m not alone in this thinking. Search for information on home equity loans online and you’ll find countless articles encouraging people to use caution when borrowing against their home’s equity. However, the general things to be wary of if you decide to go this route are:

• This loan will be in addition to the mortgage you’re already paying

• There are closing costs associated with this kind of loan (talk to your financial institution about what fees you’re responsible for)

• Using all your equity can have negative repercussions if property values drop

• If you default on your payments, your financial institution can foreclose on your home

• If you sell your house before you’ve paid off your home equity loan, you’ll need to sell your house for a price that will cover both your mortgage and the additional loan

WHICH LOAN OPTION IS BEST?

None of these loans can be labeled as “the best”, because they each have positives and negatives, and none of them will work for every situation, project, or purchase. Narrow down what you want to accomplish with the loan and figure out the total amount you’ll need to borrow, then talk with your financial institution about which choice might be best based off that information.

Although taking on new debt (or borrowing against your home’s equity) can sound kind of scary, these loans generally have positive outcomes. Make sure you can afford the additional loan payment and try not to use the full equity of your home, and you’ll be able to complete that home improvement project (or take that vacation or pay for a college education) in no time!