Home Equity Loans Pros and Cons

Home equity loans typically carry far lower interest rates than personal loans, which are also much harder to get, and certainly lower than cash advances from credit cards. This is because you're using your home as collateral for the loan, so the bank feels confident it will get its money back.

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Yes, that's the reason the interest rates on your home equity loan are so low. However, if you should fall into financial difficulty and default on your loan for any reason, your lender has the option to file for foreclosure and take your house. It's possible that you could lose a home worth, say, $500,000 because of failure to make payments on a $30,000 loan. It's important to understand this risk before you enter into a home equity loan.

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When you take out a home equity loan, you have a fixed interest rate. That means your payment doesn't increase when federal interest rates increase, as can happen with your first mortgage. Because of this, you can plan ahead, create a budget, and bypass the anxiety of not knowing what you owe from month to month.

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Before the housing crisis of 2007, getting a home equity loan was remarkably easy: if you had equity in your home on paper, you could get a loan. Since that time, lenders have begun to scrutinize home equity applications more cautiously. It's unlikely you'll be able to borrow more than 80 percent of your home's equity -- its value less what you still owe on your mortgage -- and the application process is likely to be quite stringent. The bank wants to know that it will get its money back, so you'll be asked for your tax records, proof of income, and other data showing your ability to make monthly payments.

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Your interest payments constitute a large portion of the payment you make on your home equity loan each month — but if you use the loan funds to make substantial improvements to your home, you may be able to deduct some of that interest on your taxes, up to a total loan of $750,000. Talk to your accountant before you finalize the loan to make sure you qualify for those deductions.

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Maybe you took out a home equity loan to pay off some old credit card debts. Yes, you've saved a bundle of money by doing that, since your home equity loan's interest rate is far below that of your credit cards — but you're still in debt. In addition, you've paid off the debt on your mortgage to build up equity — and now you've turned it into debt again. Because of this, it's important to use your home equity for important expenditures such as college tuition or home improvements; don't put your home up for collateral for just any reason.

While the process is tougher than it used to be, it is still easier to qualify for a home equity loan than other types. Lenders feel more comfortable lending to people with bad credit if they have the collateral of a home to help manage their risk. You'll still have to meet minimum requirements and provide all that extensive documentation, though.

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When you take out a home equity loan, you're essentially signing the bottom line on a second mortgage. Because of that, you'll pay the same kinds of closing costs and other fees that you paid when you took out your first mortgage. Yes, the interest rates are lower, but you'll have a higher up-front cost on the loan than you would on other loans. In most cases, those fees come out of the proceeds of the loan, so you end up with less money than you thought you were borrowing.

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Cash advances from your credit cards and personal loans typically top out the low five figures. With a home equity loan, however, you can access a large amount of cash fairly quickly and at a comparatively low interest rate. If you have a lot of equity in your home because you've been paying down your mortgage or because housing prices have risen in your area, you could tap into a significant amount of money with relative ease.

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