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Is a Home Equity Loan a Good idea?

I need a loan, but I’m not sure what kind of loan I really need. I need money to cover a new brakes and tires on my car plus a few other things that I’ve been putting off until I had more money. I’ve heard payday loans can be a nightmare, so I don’t want to go that way. My brother told me to take out a home equity loan since I’m about 10 years away from paying off my mortgage and my property value is still pretty good. So, is a home equity loan a good idea?

Clara D. in Green Bay, WI

Consolidated Credit’s President explains how to know decide if a home equity loan is a good idea.

Home equity loans can be risky

Hi Clara,

Thank you for your question. A home equity loan or line of credit can be a great option for dealing with debts and other financial items that need attention, but sometime it is not the smart way to go. A testament to that is the housing bubble that we just lived through. People took out home equity loans and lines of credit only to end up owing more money on their home than what it was worth. So the answer to your question is – it depends…

Understanding when is a home equity loan a good idea

A home equity loan is a secured loan. You offer your home up as collateral, and in exchange the bank extends you money that has to be paid back over a specific period. Since your home acts as collateral, you can usually get better terms on the loan than you would without collateral being offered. And you may save money on taxes based on your individual situation.

This means that you can get a lower interest rate on the loan than what you’d qualify to receive on a loan without collateral. Low interest means you’ll end up paying less money over the life of the loan.

For example, the total interest paid on a 3-year loan for $10,000 at 5 percent APR is $789.52, while at 6 percent APR the same loan would cost $951.90 with added interest. The monthly payments are also slightly higher at six percent versus five, because you have to pay more within three years to pay it off with interest added – the difference is about $5 on this example.

So on one hand there can be good reasons to use a home equity loan.

Why is a home equity loan a bad idea?

On the other hand however, you’re taking a risk that could cost you your home if things go wrong. Here’s why…

Your property acts as a financing safety net for the lender in case you don’t pay. So if you don’t pay, the lender it is within their right to take your home to satisfy the debt. This is why home equity loans can be considered a higher risk, because you can lose your most important asset if something goes wrong.

Of course, that doesn’t mean that you can’t use this type of loan and be successful. You just have to weigh the risk against the financing benefits. Is a bigger line of credit at a lower interest rate worth the risk of losing your home and how much risk would you really face?

Let’s say you have a steady job with good pay and a high level of job security at an established company; you also have a good budget in place with a solid handle on your expenses. In this case, you would have at least some peace of mind that you’ll have the means to pay the loan back. On the other hand, if you’re a relatively new hire at a company that’s going through a merger and may relocate and downsize next year, then your risk would be higher.

Keep in mind, that even if you have that great job with lots of security, the unexpected can still happen. If you get into an accident and can’t work, then your home could be at risk at a time when you really don’t need to be worrying about things like loan default and foreclosure.

Always compare home equity loans to other financing options

There’s also a question of how much better the lending terms would be on a home equity loan versus an unsecured personal loan. If your credit score is good, then I’d look into unsecured loans first. Then you at least have something to compare to so you can see if the interest, loan amount and terms on a home equity loan are more beneficial.

If you weigh your options carefully and a home equity loan is worth the risk, then just make sure you get the best terms possible and do everything you can to make every payment on time.

Good luck and let us know if you need more information to help you make your decision.

Gary Herman
President of Consolidated Credit

Read Gary’s bio

Want to know if a home equity loan is a good idea in your specific financial situation? Talk to a HUD-approved housing counselor for a free evaluation.

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