Money Management

If you’re thinking about getting a home equity loan, consider the costs of applying for this type of financing and the risk you’re taking on. Find out more. 

A home equity loan is a secured loan. When you take out a home equity loan, you borrow against the value of your home and use your house as collateral for the loan.

You may be able to qualify for a loan at a relatively affordable rate (around 6% to 8% is common right now — much lower than the typical credit card interest rate, which is usually around 17% or higher). And, if you have a lot of equity in your house, you may be able to borrow a substantial sum.

Before you move forward with this financial transaction, though, there are five things you must consider first. Here are the key questions you need to ask yourself.

1. How much equity is in your home?

Your home equity equals the value of your home minus what you owe. So if you have a $400,000 house and you owe $300,000, you have $100,000 in equity.

The more equity you have, the more you can potentially borrow. Most mortgage lenders won’t lend you 100% of the value of your house, so if you have less than 10% equity in your home, you may not be able to get a home equity loan at a competitive rate.

2. What will the process of getting the loan involve?

Getting a home equity loan can be more complicated than getting approved for other kinds of loans. You may need to provide more financial information rather than just basic details about your income and a credit check (which is all personal loan lenders usually require). You may also need to have your home appraised, which comes at a cost of several hundred dollars.

If you want to borrow quickly and with the minimum of hassle and upfront expenses, a different financial product could be a better fit rather than a home equity loan.

3. How much are closing costs on your loan?

Some lenders offer home equity loans with no closing costs, but you usually end up paying these costs one way or another. Often, you’ll be offered a higher interest rate or will be able to finance closing expenses as part of your loan.

Closing costs can actually total between 2% and 5% of the loan amount, depending on the lender and the situation. That’s a lot of money to pay upfront just for the privilege of borrowing.

4. Will your interest be tax deductible?

In some cases, interest paid on a home equity loan is tax deductible. To benefit from the deduction, you’ll need to itemize rather than claim the standard deduction. You also must have used the proceeds from the home equity loan to build a home or substantially improve upon your primary residence or a second home.

If you meet the requirements, the tax-deductible interest makes home equity loans an attractive borrowing option since the government picks up some of your costs. If you’d owe interest of $1,000 per year and can deduct this from your taxable income, you could save as much as $220 if you are in the 22% tax bracket.

5. Are you willing to put your home at risk?

Finally, the last big consideration is whether you’re willing to risk your home for whatever you’re borrowing for. You could be foreclosed on if you don’t pay your bills, so you’ll want to be 100% sure you’ll be able to cover your home equity loan costs before moving forward.

By considering these issues, you can make the best and most informed choice about whether to get a home equity loan or not.

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Home equity is secured debt, and it doesn’t make sense to convert unsecured debt to secured debt. Find out why that’s risky. 

If you have a lot of credit card debt or other consumer debt, you may want to consider debt consolidation. This process involves getting a new loan and using it to pay off other debts. If your new loan has a reduced rate, you can lower payoff costs and make the process of becoming debt-free easier.

If you’re a homeowner, a home equity loan may seem like an attractive option for a debt consolidation loan. Home equity loans tend to have lower rates than personal loans, which can make them seem like an especially good option for reducing the cost of debt payoff. But the reality is, there is one really big reason why tapping into home equity to repay debt is almost always something to avoid.

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The huge downside of using a home equity loan for debt payoff

Although borrowing against your home may seem like it’s a good idea due to the low rate, the sad reality is when you take this approach, you are putting your house in jeopardy.

In most situations, when you’re using a home equity loan to pay off other debts, those debts are unsecured. This means there isn’t any collateral that guarantees a lender will be paid. If lenders want to try to collect, they could go to court and get a judgment against you that could potentially lead to liens on your property or wage garnishment.

But, often, they won’t bother. They’ll usually charge off the debt and sell it to a collector, who will use a variety of tactics to try to recover the money but who, again, can’t easily come after your assets without court action.

When you have unsecured debt, not paying it can definitely have consequences — but those consequences very rarely, if ever, involve losing your house. If you have a home equity loan, on the other hand, then if you don’t pay the loan, it’s very likely the lender will foreclose on you as long as it thinks it can generate enough from the sale to recoup its unpaid funds and costs.

This means if you have tapped into home equity to repay unsecured debts, you have directly put your house at risk when it wasn’t before. If something unforeseen happens and you end up not being able to make the payments, there’s a very real chance your home will be lost versus almost no chance of that happening if you couldn’t pay your unsecured debt.

What should you do instead?

Instead of tapping into home equity, consider these other options for debt refinancing.

A balance transfer: This is an ideal choice if you have credit card debt to consolidate and refinance. You can get a balance transfer card with a 0% interest rate for a period of time, and then transfer your existing debt balance to it, effectively reducing your interest rate to 0% (although you will usually pay a balance transfer fee of about 3% to 4% of the transferred amount).A personal loan: Personal loans are unsecured debts that can be used for debt consolidation and refinancing. Well-qualified borrowers can typically get a loan at a lower rate than their credit card issuer would charge them, and the loan will also have fixed monthly payments and a set payoff time, which cards don’t.

Both of these options can help you deal with debt by refinancing and/or consolidating. But unlike with a home equity loan, you won’t be gambling your home on the hope you’ll be able to pay off the loan.

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I was able to dramatically reduce my monthly mortgage payments by making a lump-sum payment and then requesting the lender recast my loan. Find out more. 

Not too long ago, I decided I wanted to lower the amount I was paying each month for the mortgage on my home. I wanted a lower monthly payment to improve my debt-to-income ratio because my husband and I will soon be getting a mortgage on a second home and we didn’t want our combined mortgage payments to be too high.

I didn’t want to refinance my current mortgage to reduce the monthly payments, as mortgage rates are higher now than they were when I took out the loan. But I was able to drop my monthly bills substantially anyway. Here’s how I did it.

Recasting my loan made a big difference in my monthly mortgage payments

I was able to reduce the monthly cost of my mortgage by making a lump-sum payment that reduced my principal balance and then asking the lender to re-amortize or recast the loan.

Typically, when you make your monthly mortgage payment, the amount due is the amount of principal and interest necessary to repay your loan in full by the end of the loan period. If you have a fixed-rate loan, the monthly payment you make will be the same the whole time. If you pay it exactly as expected, you will be debt-free on the planned payoff date (usually 15 or 30 years after you took out the loan, depending on your chosen mortgage term).

When you make a large principal payment, though, the amount you have to pay back each month would theoretically be reduced. Since you cut your balance down, you don’t need to pay as much each month in order to be debt-free by the agreed upon date.

However, making a big payment doesn’t automatically result in your monthly payments dropping to adjust for your new balance. Instead, you typically must continue to pay as promised and you simply end up paying off your loan early.

When you ask your mortgage lender to recast or re-amortize your loan, things work differently. Your lender will recalculate how much you now have to pay each month, given your new lower balance, in order to be debt-free by the deadline. Since your balance is smaller, your monthly payments will be lower.

For example, say you had $120,000 left on a mortgage loan at 4% interest and your current monthly payment was $1,115.43. If you make a $15,000 lump-sum payment and ask your lender to recast your loan (which usually comes with a fee; in this example the fee will be $250), your loan balance would come down to $105,000. Your monthly payment would be reduced to $972.85, saving you about $142.58 per month.

Is recasting right for you?

If you want to lower your monthly mortgage payment without refinancing and you have a lump sum of money you can put toward this goal, recasting can make sense. It’s one of very few options you have available to reduce your monthly payment without getting a whole new loan.

But to make this happen, you first need a big sum of cash to put down. My lender wouldn’t do the recast unless we paid at least 10% of the outstanding balance. And you’ll be tying up more money in your home as well as extending your payoff time. You may decide these downsides are worth it, but don’t forget to consider them as you make your choice.

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A high deductible leaves the policyholder with a lower premium. Read on to learn why Dave Ramsey argues in favor of them. 

When buying auto insurance, home insurance, or other kinds of insurance coverage, chances are good it will become necessary to decide whether to opt for a high or low deductible.

A deductible is the amount that a policyholder has to spend personally for a covered loss. The insurer picks up the remaining bills once the deductible has been paid out of the policyholder’s bank account.

Although a high deductible means a policyholder would have to pay more for a covered loss, it’s what finance expert Dave Ramsey recommends. Here’s why.

Dave Ramsey suggests opting for a high deductible for a few key reasons

Ramsey believes that, in most situations, a high deductible policy is better than a low deductible policy primarily because of cost.

“A high deductible may sound bad, because you have to pay more up front if you have to file a claim,” Ramsey said. “But you’ll actually pay lower monthly premiums — so the longer you go without filing a claim, the more you save.”

Ramsey explained that the lower a policyholder’s deductible is, the more risk the insurer takes on. And insurance companies charge more for this added risk, because their goal is to make money. If they think they’ll have to pay out a larger sum, they have to charge more for a policy.

Ramsey said that as long as a policyholder has an emergency fund, they can cover the costs of the high deductible without a problem if something does go wrong. And, he thinks that taking on this risk personally is worth the savings on insurance premiums that will result.

Is Ramsey right?

Ramsey is right that policyholders do have to pay more to transfer more risk to an insurer. A policy with a lower deductible is more expensive. In fact, a typical driver may save around 30% on their car insurance premiums by upping their deductible for collision and comprehensive insurance coverage from $50 to $250.

In many cases, taking advantage of these savings makes sense. In fact, policyholders can often save enough money in reduced premiums over the course of about a year to cover the deductible. If a policyholder can save $200 on premiums over the course of the year by switching from the $50 to the $250 deductible, that policyholder could simply put the $200 in a bank account to use if a covered event happens and they must file a claim. They’d continue to enjoy premium savings without any added out-of-pocket expenses from there on out.

However, it’s important for each policyholder to consider their own individual situation when deciding if a high or low deductible makes sense. Some people would prefer to pay a little more over time to transfer more risk because they aren’t prepared to come up with hundreds of dollars if a covered event randomly occurs. If a policyholder would rather pay more in exchange for avoiding surprise expenses, this can make sense.

Ultimately, though, many people should consider following Ramsey’s advice and raising their deductible if they have the savings to cover it and don’t think a covered loss is likely to occur in the short term.

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Dave Ramsey believes debt is always dumb, but debt can be effectively used as a tool if you’re smart about how you borrow. Learn when debt can make sense. 

Dave Ramsey is not a fan of debt. In fact, the finance guru believes that borrowing money is always dumb. But, while Ramsey may have a case that certain kinds of loans or credit cards can get you in trouble, viewing all debt as bad is simply not a sound approach to making financial decisions. Here’s why.

This is what Dave Ramsey had to say about debt

Ramsey has made it clear that he doesn’t think there’s ever a reason to borrow because of the financial danger that being in debt presents.

“Debt always equals risk, and it’s always dumb,” he said. He gave the example of someone who had a mortgage loan on a rental property during the height of the COVID-19 pandemic with a tenant who couldn’t pay their rent. Ramsey said that person would be in a much worse position than someone who had no debt and an emergency fund with $20,000.

He also explained that debt can lead to trouble even outside of these dire situations. “It doesn’t even take something as extreme as a global pandemic or an economic collapse (2008, anyone?) for debt to become a nightmare,” he warned. “That’s because debt always equals risk, and more debt always equals more risk.”

Here’s why Dave Ramsey is wrong

While Ramsey’s points about risk may seem logical, the reality is that you can absolutely take on some debt with minimal risk — and many people should do that.

Risk is not necessarily a bad thing when it comes to your money. Take investing, for example. You could put all of your money into a safe savings account that’s FDIC insured and have no risk of losing your money — but you would earn very limited interest that often wouldn’t be enough to keep pace with inflation. Or you could take on some risk by putting some of your money into an S&P 500 fund, which has produced average annual returns of 10%. In these scenarios, you’d be better off investing some of your money — as Ramsey himself acknowledges.

The key, when it comes to both investing and debt, is to only take calculated risks.

Take that landlord Ramsey was talking about above as an example of someone who would be in a bad financial position if their tenant couldn’t pay rent during the pandemic. There were government protections in place for that landlord to prevent foreclosure, and the landlord would ultimately have been entitled to get paid back the unpaid rent (or to evict the tenant).

The landlord could also have used savings to pay the mortgage while continuing to hold onto the house, which would produce income later, or could potentially have sold the house for a profit when home prices were skyrocketing. Having this debt didn’t leave the landlord without options — and, at the end of the pandemic crisis, they’d still have that real estate asset (or the money earned from selling the home). So, would they really be worse off?

If you borrow too much with no plan to pay it back or you’re borrowing for something that won’t increase your net worth in the long term, then you are likely making a bad decision, and Ramsey is right — debt isn’t smart in that situation.

But if you have a good reason for borrowing (like buying a house or starting a business), emergency money to make payments on the loan if times get tough, and a plan for how your borrowing will help you grow your wealth in the long run, then Ramsey is dead wrong and debt isn’t dumb at all.

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Homeownership can be a good investment regardless of rates. Read on to learn why higher mortgage rates haven’t scared me off from buying a home. 

Mortgage rates today are much higher than they were during the heart of the pandemic. In fact, in recent months, rates have been higher than they’ve been in years. Despite the fact that rates are up so much, I’m still moving forward with buying a house — and borrowing to do it.

Here’s why I don’t really care that rates are higher and I’m moving forward with my purchase anyway.

I can refinance my loan later

The biggest reason I don’t care that I’m going to pay a higher mortgage interest rate right now is that I know my rate is not necessarily set in stone forever. If rates go down in the future, I’ll have the option to refinance. But, if rates go up for a longer period of time, I’ll be locked in at my current rate and I won’t have to pay more.

Since no one can predict with certainty if rates will go up or down, I’d rather lock in now at the current rates. There’s no real risk and all upside if I do this, since I can’t go back in time and get today’s rates if mortgage loans happen to become more expensive tomorrow. But I can get lower future rates tomorrow if things go well.

I’m buying a house that’s well within my budget

Another big reason I don’t care that much about high rates is because I’m being very conservative in deciding how much house I can afford. I’m going to purchase a property that is much less expensive than the bank said I could buy based on my income.

Since my mortgage payment won’t be a struggle, it’s annoying to have to pay a little bit of extra interest, but it won’t derail my personal finances or cause me ongoing money stress.

I believe homeownership is a good investment

Finally, the last main reason why I’m eager to buy despite the fact that interest rates are up is because I believe homeownership is still a good investment. I have sold several properties in the past and always made a handsome profit on them. I know that there’s no guarantee this will happen forever, but since I’m buying in a market where demand is growing and where remaining properties are somewhat limited, I think the odds are in my favor.

I’d also rather pay a bank interest, while also building equity at the same time by paying principal payments too. I prefer this to spending money on rent and having nothing to show for it in the end.

For all of these reasons, I’m not letting higher interest rates today stop me from purchasing the home I want. Of course, anyone who is thinking about buying a house of their own should consider whether doing so makes financial sense at these rates — and given your own financial circumstances. You may come to a different decision, but don’t assume buying is a bad idea now just because you won’t get the record low rates people have enjoyed in recent years.

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We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers.
The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.The Motley Fool has a disclosure policy.

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