Why a home equity loan is better than these 5 alternatives
Inflation remained stubbornly high in January, possibly pushing back any interest rate cuts by the Federal Reserve. Still, the long line graph indicates a cooling trend, albeit a bumpy one. Nevertheless, lenders have already begun lowering mortgage rates in anticipation of any cuts to the federal funds rate. According to Freddie Mac, the rate on a conventional 30-year fixed-rate mortgage is currently 6.90%, down from 7.79% in late October.
The good news for homeowners is that despite dips in some areas, prices are generally holding steady and preserving home equity for owners. A 2023 report from the real estate analytics firm CoreLogic says the average homeowner in the U.S. holds $300,000 in home equity.
With lower interest rates than other forms of lending, home equity loans may be a good option for borrowers. The best lending option depends on a several factors, including the loan amount, borrowing costs and your time horizon for repayment. However, a home equity loan could be a better option than the below five alternatives in specific situations.
Considering tapping into your home equity? See what interest rate you could qualify for here now.
Why a home equity loan is better than these 5 alternatives
Here are five lending options that a home equity loan may be preferable to.
Credit cards
As of February 27, the average home equity loan interest rate is 8.78%. That's substantially lower than the average credit card interest rate of 22.75%, according to the Federal Reserve. If you're looking to borrow a substantial amount, such as $50,000 for a home renovation project, you could save thousands of dollars in interest charges over the life of the loan.
"When you need a sizable sum and can repay it over a longer period, a home equity loan is the better choice," says Mike Roberts, co-founder of City Creek Mortgage. "The interest rates on home equity loans are generally lower, making them more cost-effective."
Keep in mind, home equity loans use your house as collateral, which means the bank could foreclose on your home if you default on the loan. If you need a smaller amount, a credit card or other alternative may be less risky, especially if you can repay the amount quickly.
Compare your home equity loan options here to learn more.
Personal loans
As with credit cards, home equity loans may be preferable to personal loans because they usually come with lower interest rates. They also have higher borrowing limits, up to 75% to 85% of your home's equity. As mentioned, U.S. homeowners have an average of $300,000 in equity, which means they could potentially borrow from $225,000 to $255,000. By contrast, borrowing amounts on personal loans typically don't exceed $100,000. If you're consolidating a substantial amount of debt or undertaking a pricey home improvement project, the higher borrowing limit and lower rates may be advantageous.
Bill Westrom, the CEO and founder of TruthInEquity.com, advises borrowers refrain from borrowing the maximum amount, even if they qualify. "If we use 2008 to 2009 as a teaching lesson when home values fall, you might find yourself in a negative equity position that might take years to recover from."
Cash-out refinance loans
If you took out your current mortgage before 2022, you likely have a more favorable rate than what you'll find on the market now. Specifically, mortgages taken out between 2019 and 2021 have average interest rates below 4.00%. Refinancing at today's higher rates doesn't make much sense. A home equity loan allows you to access the funds you need without changing the terms of your original mortgage.
"If you have a first mortgage with an interest rate of 4.00% or less, do not ever let it get away," says Westrom. "There really is no complimentary argument for the cash-out refinance if you have a low, low rate already."
Home equity lines of credit (HELOCs)
While home equity lines of credit (HELOCs) include many of the same benefits as home equity loans, there are times when the latter can be more advantageous. For starters, home equity loans can provide you with a large sum of money upfront, whereas HELOCs are designed to draw funds as needed over time.
Additionally, home equity loans come with fixed interest rates, while HELOCs typically have variable ones. With a stable rate and payment that remains the same throughout the loan, a home equity loan is more predictable and easy to manage. It also can save you on interest charges as it isn't subject to interest rate fluctuations.
Learn more about your HELOC options here.
401(k) loans
Both a 401(k) loan and a home equity loan allow you to "borrow from yourself." A 401(k) loan allows you to borrow up to $50,000 in emergency cash from your retirement plan, and pay yourself back within five years with interest, usually a point or two higher than the current prime rate.
However, borrowing from your 401(k) comes at a massive opportunity cost. The money you withdraw will no longer earn interest, and it could take years to regain your former account position. During those five years of repayment, you could forfeit your employer's matching contributions, and the lower account balance will yield less earnings.
With a home equity loan, you'll pay interest charges, and the risk to your home must be strongly considered. However, a well-planned home equity loan with affordable payments could be considered a more favorable option than depleting your retirement savings.
The bottom line
A home equity loan can be more advantageous than the alternatives above in many situations, but not always. Deciding whether to get a home equity loan, one of these five alternatives or another financing option should be based on how each option addresses your unique circumstances. Explore your options and read the fine print before proceeding with any loan offers. Finally, make sure you can comfortably afford the payments on any new loan or credit you're considering before taking on new debt.
