Home equity loans 101: Are they right for you?

Owning your home allows you to build equity rather than shipping a rent payment off to a landlord. And having that equity means that if unexpected expenses pop up, you can access funds in the form of loans backed by your home.

Of course, taking out a loan against your home isn’t something you should do lightly or on a whim. But if you do your research, understand the terms of your loan, and have a solid plan for paying it back, you can use home equity loans to your benefit.

What Is a Home Equity Loan?

You’ve probably heard of home equity loans referred to as “a second mortgage.” This term is used because you’re using the equity in your home as collateral for the loan, meaning that if you default on the loan, the financial institution can take your home to make the debt whole. Home equity loans are based on your home’s current market value and the remaining balance due on your mortgage. These loans are typically fixed-rate, while home equity lines of credit, or HELOCs, have variable interest rates.

What Are the Benefits of a Home Equity Loan?

Because you’re using your home as collateral, home equity loans are a form of secured debt, while things like credit cards are unsecured. Unsecured debts do not have collateral attached, so they generally come with higher interest rates. That means a home equity loan is likely to come with a lower interest rate, meaning your money goes further. Home equity loans are for a fixed amount and come with fixed monthly payments, making planning and budgeting easier.

What About the Drawbacks?

You should always understand the risks and terms of any debt you take on, no matter what form. Like all loans and debts, home equity loans do have some drawbacks you should know about. For example, if you want to get a lower interest rate on the loan, you first have to refinance your house, which means extra steps and costs to obtain the refinancing. And if you fall behind on your payments, you could eventually lose your home. Additionally, if the value of your home decreases, even if the cause is out of your control, like a downturn in the local real estate market, you could end up underwater on your home. That means you owe more than your home is worth.

How Do I Know a Home Equity Loan Is for Me?

You should only take out a home equity loan if you have a solid reason that will provide value down the road, such as paying for college, consolidating debt, covering emergency expenses, or remodeling your home to improve its value in the future.

As with all financial products, you should take an honest accounting of your existing finances and develop a plan for how you’ll use the money and how you’ll pay it back. Remember that failing to do so with a home equity loan could mean losing your home. Finally, if you choose to move forward with a home equity loan, make sure you’re working with a trusted professional who has your best interests in mind.