Pros and Cons of Leveraging Your Home Equity for Financing

You can use your home equity to access financing, but it's important to consider the pros and cons of doing so before you apply for any loans or lines of credit.

Photo by Binyamin Mellish on Pexels

If you're a homeowner who needs to borrow money, tapping into your home equity is a common strategy that could help you accomplish your goal. Yet before you fill out an application for a home equity loan or line of credit, it's important to do your research. Not only should you understand how this type of financing works, but you'll also want a clear overview of the pros and cons of this type of credit before you put your home on the line.

What Is Home Equity Financing?

When you borrow money from a lender, you can choose between two primary types of financing—secured and unsecured. With unsecured financing, you don't need to back the loan, credit card, or line of credit with any type of asset. But if you open any type of secured credit, the lender will ask you to pledge an asset (aka collateral) that it can seize should you fail to repay your credit obligation as promised.

Home equity financing falls into the category of secured credit. Two common examples of home equity financing are home equity loans and home equity lines of credit, also known as HELOCs. With both financing options, a portion of the equity in your home serves as collateral for the money you borrow from a lender.

Home equity is the difference between the value of your home and the amount you owe on your mortgage. So, if you owe $100,000 to your mortgage lender but your home is worth $250,000, you have $150,000 worth of equity in your property. Some lenders may let you borrow up to 85% of your home's value with a home equity loan or HELOC (including your primary mortgage), depending on your FICO® Score and other factors.

Pros and Cons of Home Equity Financing

As with any type of financing, there are benefits and drawbacks to leveraging your home equity to access credit. It's important to consider all the ways (positive and negative) that home equity-based financing could impact you before you decide if this type of financing makes sense for you.

Pros

• Competitive Interest Rates: When you back a loan with the equity in your home, there's less risk involved for the lender. As a result, the interest rates on home equity loans and HELOCs are often lower than you'll find on other types of financial products (such as credit cards or unsecured personal loans). Keep in mind, however, that every situation is different. Your FICO® Score and other factors will impact the financing offers you receive.
• Possible Tax Deduction: In some cases, you may be able to deduct the interest you pay on a home equity loan or a HELOC from your taxes. However, you'll need to meet IRS requirements, including using the funds you borrow to buy, build, or substantially improve a qualified residence. There are also limitations on the amount you can deduct. If you have questions, it's wise to speak with a trustworthy tax advisor for advice about your specific situation. But if you're eligible, the potential deduction could add up to a meaningful savings on your federal tax return.
• Borrowing Flexibility: Lenders often place few restrictions on how you can use the cash you borrow with home equity loans and HELOCs. So, if you're looking for a flexible borrowing solution, home equity financing might be a good fit.

Cons

• Risk of Foreclosure: With home equity financing, you pledge your home as collateral to back the loan or line of credit you secure from a lender. If you're unable to repay the money you borrow as promised, the lender could foreclose on your home to recuperate its losses. This is a significant risk that you should make sure you're 100% comfortable taking before you consider this type of financing.
• Fees: Every home equity loan and HELOC is different. However, it's common for lenders to charge fees (e.g., closing costs, origination fees, appraisal fees, annual fees, etc.) on top of your annual percentage rate for this type of financing. Fees may be due at closing or could come out of your loan proceeds. It's important to compare multiple lenders and financing options to make sure you get the best deal available.
• Additional Monthly Payment: When you borrow against your home equity, you essentially owe a second mortgage payment on your home. This additional payment may increase your debt and could impact your household budget. Some people use home equity loans or HELOCs to consolidate high-interest credit card debt. But if you're borrowing additional money for other purposes, you should be extra cautious and make sure you can afford the new payment before you apply for financing.

Bottom Line

Home equity financing can be a solid and more affordable financing solution for many borrowers. But it's not a perfect fit for everyone. If you feel uncomfortable about pledging your home to secure financing, it's probably best to explore alternative financing options.

Keep in mind that with any type of financing, home equity or otherwise, a good FICO® Score could work in your favor. It's wise to review your credit before you apply for a new home equity loan or line of credit. And if you find that your credit isn't in the best shape, you may want to work toward improving your FICO Score to hopefully put yourself in a better borrowing position in the future.

Get your FICO® Score from FICO, for free. No credit card required.

Michelle Black

Michelle Black, Founder of CreditWriter.com is a leading credit expert, financial writer, and speaker with nearly two decades of experience. Her work has been featured with major outlets such as Forbes, Reader's Digest, and U.S. News and World Report.