When does a home equity loan make sense, and when does it cost you more than it saves?

Summary

It makes sense when you need a known amount for a one-time expense and can carry a fixed payment for the full term without counting on a later refinance. It tends to cost more than it saves when you use it to stretch a short debt over a long term, or when the thing you're paying for doesn't justify putting the house up as collateral. The CFPB's plainest warning is that "If you cannot pay back the HEL, the lender could foreclose on your home."

Paying off a car loan with a 20-year loan

The CFPB gives this exact case as a warning. Taking out a mortgage to pay off a five-year car loan "may have you making payments and paying additional interest" for "ten, fifteen, or even thirty years."

Here is what that looks like in dollars, even with the rate held the same. Borrow $20,000 at 6.75%, the lowest APR Regions Bank advertises on its home equity loan. Paid off over five years, the payment is $393.67 and total interest is $3,620.15. Regions' shortest term is 10 years, where the payment drops to $229.65 and interest rises to $7,557.79. At its longest term, 20 years, the payment is $152.07 and interest reaches $16,497.47, more than four times the five-year figure. (These are our calculations.)

The lower payment is real. So is the extra $12,877 in interest.

What else goes wrong with consolidation

On consolidation in general, the CFPB writes: "When you use home equity to pay off other debts you really aren't paying them off. You are merely taking out one loan to repay another." It also notes that the rates "may be lower in the short term, but that's only because you are using your home as collateral."

In its guidance on consolidating credit card debt, the CFPB adds three more costs. Closing costs "can be hundreds or thousands of dollars." If home values fall, the loan can leave you "underwater," which makes selling or refinancing harder. And equity spent on old card balances "may not be available in an emergency or for expenses like home renovations or repairs." If debt problems have already lowered your score, it says, you probably won't get a low rate on a home equity loan anyway.

When a lump sum fits the expense

A home equity loan pays out once, usually at a fixed rate, with the same payment each month. That shape matches a single bill you already have a price for, such as a new roof with a signed quote.

Spending that comes in stages, with a total you don't know yet, is a closer match for a HELOC, where interest runs only on what you've drawn. The trade-off is a rate that usually floats and a payment that often jumps once the draw period ends. The loan vs HELOC guide covers that choice.

If you might sell in a few years

A 20-year loan that ends with a sale in year four is really a four-year loan with a large payoff at closing. On a long term, only a small part of the balance is gone by then. The owed-at-sale article works through what is left on a 10-, 15- and 20-year loan after three and five years.

Borrowing to invest

The CFPB singles this out too. "There is no such thing as a 'risk-free' or 'guaranteed' investment," it says, and an investment that loses value can leave you unable to repay a loan secured by your home.

Sources

Written by Kaz (pen name). Figures are copied from providers' published pages on the dates shown. We have not used these products. Corrections: contact form.