A home equity loan is where you borrow money from a bank or lender using your home as collateral. Equity is the value of your property based on how much you have paid down on your first mortgage. While equity loans often provide lower interest rates than unsecured financing, there are risks and disadvantages.
To secure your home equity loan, your lender puts a lien on your property in the same way your original mortgage lender does. This puts you at increased risk of property loss if you don't meet your repayment obligations. A job loss or other bills piling up that cause you to miss first or second mortgage payments can become a serious problem.
Not only do you have an additional lien against your property with a home equity loan, but your monthly debt commitment rises. Unlike credit lines, an equity loan is repaid in monthly installments, similar to your first mortgage. This means you owe the installment amount each month until your debt is entirely repaid. Adding another $200 to $300 or more in debt payments combined with your property serving as collateral can give homeowners a headache.
While your home is the place you live, it is also a property investment. Borrowing an additional amount against your equity reduces the net worth of your property asset. This means that if you ever sell your home, you would walk away with less money because you have to pay off two loans. Plus, paying off additional principal and interest each month prevents you from paying down your first loan more quickly.
A disadvantage of home equity loans relative to a home equity line of credit, or HELOC, is less flexibility. A HELOC is a credit line based on your equity. It is still secured by your property, but you only borrow funds as needed. This is helpful when you are unsure of the need, such as with a new business or college education. An equity loan is a lump sum distribution, so you have to choose the specific amount to borrow upfront.
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