Is a Home Equity Loan a Good Idea?

Home equity hit a record high of $9.9 trillion at the end of 2021. If you’re one of the many Americans who are currently sitting on an ocean of untapped home equity, you’re likely getting advertisements encouraging you to take out a home equity loan. Is one a good idea for you?

How Home Equity Loans Work

A home equity loan is a loan that allows you to take out a one-time lump sum and pay it back at a fixed interest rate with equal monthly payments over an agreed-upon time frame. Home equity loans offer lower interest rates than other forms of unsecured debt like credit cards and personal loans because they use the equity you have in your home as collateral for the loan. 

Home equity loans, home equity lines of credit, reverse mortgages, and cash-out refinances are all ways to get cash by borrowing against your home. By using your home’s equity in this way you are taking on two main risks. If you can’t afford to pay your loan(s) back, you could lose your home in a foreclosure, and if your home’s value decreases, you could become underwater on your loan(s). In that case, you won’t be able to sell your home without taking a financial loss.

When a Home Equity Loan Is a Good Idea

A home equity loan can be a good idea when used to fund a project that will directly increase your home’s equity. Tapping into your home’s equity through a loan decreases the equity you have in your home until the loan is paid back. Using the loan to invest in a project that will increase your home’s value can help mitigate the risk of the loan. 

A home equity loan is a comparatively good idea when considering a reverse mortgage as they have much lower fees, but should still only be used when financing a project that will increase your home’s value.

Using a home equity loan to consolidate high-interest debt can be a good idea as long as you have the discipline and changed circumstances to pay off the home equity loan on time. Make sure you are addressing any underlying habits that could have caused the high balance of debt, like overspending simultaneously, so you don’t end up stuck in a debt spiral.

When a Home Equity Loan Is a Bad Idea

In general, a home equity loan is a bad idea when it is used for anything other than something that will directly increase your home’s value. A home equity loan is a particularly bad idea when used frivolously. Don’t use a home equity loan to fund a lifestyle that your income can’t sustain. If you can’t afford luxury dinners, cars, and vacations on your income, don’t erode your home’s equity to temporarily live that lifestyle.

The Bottom Line

A home equity loan, like many other loan products, can be a good idea in some circumstances and is a terrible idea in others. Understand the risks and consider whether risking your home is worth whatever you’re taking out the loan for. In general, you should only consider a home equity loan for something that can increase your home’s value.