Home Equity Loans – Pros & Cons

by David@MoneyNing.com · 0 comments

So now that I’ve owned my home for 10+ years, I’m getting offers left and right for home equity loans. While I am doing my own research, I would be most interested to read your take on them!

Congratulations. Getting offers from lenders to borrow money most certainly means that you don’t need the money. After all, no lender will offer debt to customers who they don’t believe can make the payments. Having said that, a huge influx of cash certainly gets the juices flowing. I can put it all in the market to further my wealth. Or remodel the kitchen remodel. Or get a new car. My home equity is just sitting there doing nothing anyway. Why not take advantage?

But First, What is a Home Equity Loan?

A home equity loan is basically like a mortgage, but people only get one of these loans if they are already borrowing. That’s why these loans are often called a second mortgage. Conceptually, it’s easy for consumers to understand. Their house is already serving as collateral on a loan and they dutifully make payments. Now that their home’s value has gone up, there’s more equity and they can take money out via a second mortgage based on the increased value.

Note that a Home Equity Loan is different from a Home Equity Line of Credit (HELOC). The former is like a mortgage where you receive a lump sum upfront and make installment payments until it’s paid off, while the latter is a credit line where you can choose to tap into (or not) at your discretion.

The Big Negative for Home Equity Loans

When you default on any loans that are secured by the value of your home, the lenders may initiate foreclosure proceedings. However, the way the process works is that your mortgage will first be paid before the lender of your home equity loans ever gets a dime. That’s why your lender may not pursue foreclosure if you stop paying your home equity loans if your home is worth less than what you are owed on your primary mortgage. To compensate for the lender’s increase risk, home equity loans on average have much higher interest rates.

That’s why most people don’t opt for home equity loans. After all, why would anyone pay more for essentially the same thing when they can just take out a cash-out refinance? Some of you may be thinking that there’s no risk of defaulting on a home equity loan if they won’t foreclose on your property if you don’t make payments, which most certainly is a huge plus. But the lender can still decide to sue you personally to reclaim that debt.

Tax Consequences of Home Equity Loans

In the past, additional equity taken out from a cash-out refinance is not tax-deductible unless it’s used to pay for improvements for the home. Meanwhile, a home equity loan’s proceeds can be used for anything and still qualify for the mortgage interest deduction. This drastically closed the gap between the higher interest rate of home equity loans and the lower rate on mortgages for those people who were taking loans out to, say, consolidate debt or make consumer purchases.

However, the Tax Cuts and Jobs Act of 2017 drastically changed the calculus. These days, both additional money taken out via a cash-out refinance and home equity loan proceeds are treated the same way for tax deduction purposes. According to the IRS, the mortgage interest deduction is only allowed for this money if it’s is used to “buy, build, or substantially improve the taxpayer’s home that secures the loan.”

Cash-Out Refinance vs a Home Equity Loan

Every loan is different, but borrowers can expect to pay roughly a 0.125% extra in interest for a cash-out refinance versus a standard refinance that doesn’t require the lender to send extra money to the borrower. On the other hand, borrowers can expect to pay 1%, 2%, or even 3% more per year in interest for a home equity loan.

Some believe it’s easier to qualify for a home equity loan than to simply take out a cash-out refinance, but that’s just not true. Lenders will look at all your debt, whether it’s separate or combined into the same loan. If you qualify for a home equity loan, you likely qualify for a cash-out refinance. In fact, you can argue that it’s easier to qualify for a refinance because the interest payments are lower.

Home equity loans are really for people who want to leave their primary mortgages alone. It’s possible that the borrower got a killer deal on a mortgage that he or she can’t easily replace.

This could be due to several reasons. Perhaps the rates have gone up substantially since the loan was taken and a refinance just means having to pay more on the entire loan balance. Or it could be because the lender made a deal with the borrower to lower their interest rate on a mortgage. This isn’t something lenders do often, but these deals were prevalent during the financial crisis when scores of people were having trouble making loan payments. Back then, it wasn’t unheard of for lenders to lower people’s mortgages down to as low as 1%.

It’s also possible that a borrower got a really low-interest rate because they worked with an employer and got a sweetheart deal as a job incentive. Finally, a borrower could have paid for points to lower their interest rate, and getting a new loan means that they’ll have to pay for the points again to lower the rate.

On the surface, it seems that cash-out refinances are the easier and simpler approach to freeing up home equity, but you can only really decide which route is more beneficial after you run the numbers for your own situation.

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