Learn about the pros and cons of alternative options
Disadvantages of Using a Home Equity Loan
While many homeowners appreciate the flexibility that home equity loans offer, there are some drawbacks to this type of financing. Among the downsides is the fact that your home secures these loans. So if you are no longer able to make payments – for example, if you lose your job – you could lose your home.
Additionally, this type of loan adds a payment to your budget each month. If your cash flows are tight and you are using the funds for purposes other than consolidating your bills, a second mortgage may not be suitable for you.
Owning a home equity loan may also limit your ability to refinance your primary mortgage. So if you want to refinance for better terms on your original mortgage, you may want to postpone getting a home equity loan. Consult your bank or financial advisor for guidance on your specific situation.
Home Equity Line of Credit (HELOC)
A home equity line of credit, or HELOC, is another type of second mortgage. It is similar to a home equity loan because you use the equity you have built up in your home. However, unlike a standard loan, a HELOC works more like a credit card with a revolving line of credit.
You are approved for a certain amount of money. You can access those funds whenever you need them during the loan draw period. During this time, you only pay interest on the money you have used.
HELOCs typically have variable interest rates. So among the drawbacks of these loans, your payments will not be the same every month, meaning you have unpredictable monthly payments.
Once the draw period ends, you will need to start repaying the principal, which means your payments will be larger. In some cases, the bank may require a balloon payment, or full payment, although most HELOCs offer repayment terms ranging from 10 to 20 years.
If you cannot afford the larger payment, your bank may allow you to refinance your HELOC.
Cash-Out Refinancing
Cash-out refinancing is another option to access the equity in your home. This type of loan occurs when you take out a new primary mortgage for an amount larger than what you currently owe. Similar to a home equity loan, you receive this extra money in the form of cash, and you can spend the funds however you wish.
With cash-out refinancing, you will not add a second payment each month. You can obtain cash-out refinancing for an amount that does not exceed your current monthly payments. However, the term of the loan will be extended. Also, because cash-out refinancing is a primary mortgage, you are likely to qualify for better interest rates.
Moreover, the lender may not require the same high credit score for approval on cash-out refinancing as compared to a home equity loan. So if you do not have a good credit history, this may be a good alternative.
You must keep in mind that whenever you refinance, you have to pay closing costs. If you do not have much money upfront, it may make sense to take a home equity loan.
Reverse Mortgage
If you are at least 62 years old, you may qualify for a reverse mortgage. This type of loan allows you to use the equity in your home to supplement your income during retirement.
Not…
You must make any payments with a reverse mortgage as long as you live in the home. These terms can save you money right now. The loan is due when the last borrower dies or moves out of the home. At that time, you or your heirs can sell the house to repay the loan. If the sale price isn’t enough, you or your heirs are responsible for covering the difference.
Reverse mortgages have some downsides, such as high fees. You may need to pay for startup costs, mortgage insurance, and closing costs. Due to these limitations, a reverse mortgage may not be financially suitable for everyone. It is advisable to consult a financial advisor about the options available for your situation.
Personal Loans
A personal loan is another alternative to a home equity loan. With this type of loan, you can borrow money and use it for any purpose you desire. Unlike a home equity loan, you do not have to use your home as collateral.
There are two main types of personal loans: secured and unsecured.
Secured personal loans: A secured personal loan uses your assets as collateral. If you cannot repay the loan, the lender can take funds from your account to cover the cost. Because there is less risk for the lender, you may be able to obtain lower interest rates.
You can use many different assets as collateral, including your home, but you can use other assets alongside your home to support a secured personal loan. You can use a savings account, a stock portfolio, or even your car, for example.
Unsecured personal loans: An unsecured personal loan does not require collateral. However, this means there is more risk for the lender, as they could lose money if you cannot repay the loan. As a result, obtaining these loans is more difficult.
You may need good or excellent credit to get approved for an unsecured personal loan. Even with excellent credit, you are likely to pay a higher interest rate compared to a secured loan or a home equity loan.
Credit Cards
Credit cards can be alternative options to home equity loans. However, they should be used with caution as they typically carry higher interest rates.
You can finance a project using your credit card and pay it off over time. Some credit cards offer a promotional 0% interest period, meaning you won’t accrue interest on your purchases until the promotional period ends. If you can pay it off before the 0% interest period ends, you essentially get a free loan. However, after that period, interest is applied to the remaining balance.
Read the terms carefully, as some cards impose penalty interest rates in addition to other potential fees or penalties.
Other Asset-Backed Loans
Other asset-backed loans may be suitable for your financial situation. Here are three types to consider:
401(k) Loans
If you have a 401(k) retirement account, which is an employer-sponsored account, you may be able to borrow money from it. With this type of loan, you can borrow up to $50,000 or half of your account balance, whichever is less. However, the loan typically must be repaid within five years.
One of the main downsides of a 401(k) loan is that you are borrowing from your future retirement funds.
Car Title Loan
A car title loan can provide cash in emergencies. However, these short-term loans, which often last only 30 days, carry very high-interest rates.
You will give your car title to the lender until the loan is repaid. If you cannot repay the loan on time, you will incur significant fees and may lose your car.
Loan
Certificate of Deposit
You can use any personal property as collateral to obtain a loan, including the value of a Certificate of Deposit (CD). In the event of a financial emergency, this type of loan allows you to access the funds in your CD without paying an early withdrawal penalty. Check with your bank for any other potential fees.
How much equity do you need to qualify for a home equity loan?
While lending requirements vary, it is typical to need at least 15% to 20% equity to qualify for a home equity loan. From that amount, you can usually withdraw 80% to 85% in cash.
How long does it take to get a home equity loan?
There is a lot of paperwork involved when applying for a home equity loan. It can take around 45 days, although some lenders may be a bit faster or slower.
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Sources:
Federal Trade Commission. “Home Equity Loans and Home Equity Lines of Credit.”
Consumer Financial Protection Bureau. “Does a HELOC affect my ability to refinance my first mortgage?”
Federal Trade Commission. “Reverse Mortgages.”
National Credit Union Administration. “Personal Loans: Secured vs. Unsecured.”
Financial Industry Regulatory Authority. “401(k) Loans, Hardships, and Other Important Considerations.”
Federal Trade Commission. “What You Need to Know About Payday Loans and Vehicle Title Loans.”
Federal Trade Commission. “Home Equity Loans and Home Equity Lines of Credit.”
Source: https://www.thebalancemoney.com/alternatives-to-a-home-equity-loan-5271406
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