June 16, 2024
Alternatives to a Home Equity Loan

Do you need money for a home improvement project or other major one-time expense? Home equity loans are a popular way to finance such things, but they’re not your only option. Consider these alternatives if you want to borrow a lot of money.

Key Takeaways

  • A home equity loan is just one of many ways homeowners can borrow money to cover large expenses.
  • Other methods can have advantages, such as not putting your home at risk, easier qualification, getting cash in your bank account faster, or costing less in the long run.
  • Alternatives can also have disadvantages, such as not allowing you to borrow as much, having a higher interest rate, or requiring you to give up more control of your future finances and living situation.

Cash-Out Refinance

Purpose – A cash-out refinance could be a better option than a home equity loan if you can get a better interest rate on your first mortgage.

Method – With this type of refinance, you’ll get a new, larger first mortgage. The lender will first put the proceeds toward paying off your existing mortgage and covering the closing costs on your new mortgage. The balance is your cash out, and you can use it however you want.

Pros – Instead of having two loans, as you would with a home equity loan and first mortgage, you’ll have one loan and one monthly payment. Even better, first mortgages usually have lower interest rates than second mortgages, which could save you money.

Cons – You might pay more interest in the long run if your cash-out refinance means taking more years to completely pay off your home. Also, the closing costs on a first mortgage are usually 2% to 5% of the amount you borrow, whereas lenders sometimes waive the closing costs on home equity loans.

Home Equity Line of Credit (HELOC)

Purpose A home equity line of credit (HELOC) might make more sense than a home equity loan if you want more flexibility in how much you borrow and when.

Method – As with a home equity loan, a HELOC is secured by your home equity, and the amount you can borrow depends on how much your home is worth, your credit score, and your debt-to-income (DTI) ratio. While you can borrow your full credit limit as soon as your loan closes, the traditional way to use a HELOC is to borrow smaller sums as you need them. A HELOC typically has a draw period of 10 years during which you can borrow against your credit line. After that it usually has a repayment period of 20 additional years during which you must make fully amortizing interest and principal payments and can no longer borrow against your credit line.

Pros – The initial interest rate is usually one of the lowest loan borrowing rates available, and you may only have to pay interest, not principal, during the draw period. U.S. Bank’s interest rate for a HELOC as of June 2, 2022, is 4.20%, while Freddie Mac has a 5.09% rate for a 30-year fixed-rate mortgage and 4.32% on a 15-year one.

Cons – You can lose your home if you can’t pay back your HELOC, and the loan’s variable interest rate can make your monthly payments harder to budget for.

Personal Loan

Purpose – A personal loan can make more sense than a home equity loan if you don’t want to use your home as collateral or need money fast.

Method – A personal loan can be secured or unsecured, but it’s often the latter. You can use the money however you want. You’ll get a fixed interest rate and a fixed repayment period.

Pros – Application for a personal loan is easier, requiring far less paperwork than a home equity loan. How much home equity you have is irrelevant. You might get approved and receive money in less than 24 hours.

Cons – You may not be able to borrow as much if the loan is unsecured. Also, personal loans often have shorter repayment terms than home loans, though there may be longer terms on larger loans.

For example, let’s use Lightstream’s online loan calculator to check rates and terms. If you borrow $100,000 for a “home improvement/pool/solar loan,” you might be able to repay your loan over anywhere from three to 20 years with an annual percentage rate (APR) as low as 4.99% for a shorter term and 6.49% for a longer term. If you only wanted to borrow $10,000, your maximum loan term would be seven years, with an APR of 6.99%. You could also repay it in three years with an APR of 5.49%.

You’ll still face consequences if you default on a personal loan, including damaged credit, debt collection attempts, and judgment liens. The last can turn unsecured debts into debts secured by your home in some states, such as California, but not others, such as Texas.

Shared Appreciation Mortgage

Purpose – A shared appreciation mortgage allows you to cash out a portion of your home equity without a loan.

Method – Instead of borrowing money, you give an investor partial ownership of your property. Through partial ownership, the investor (often a shared mortgage appreciation company) stands to benefit if your home’s value increases. Similar to a home equity loan, you may need a specific credit score and home equity percentage to be eligible. Qualifications vary by company.

Pros – This arrangement doesn’t require you to make monthly payments.

Cons You will pay an up-front fee, and the shared appreciation arrangement will have an expiration date. For example, you may be required to pay back the investor within 30 years, and to pay them back you’ll either have to come up with the cash or sell your home and repay them through a portion of the proceeds.

What Are My Options if I Don’t Qualify for a Home Equity Loan?

If you don’t qualify for a home equity loan because you don’t have enough equity, consider a personal loan. If you don’t qualify because your credit score is too low, you may want to prioritize improving your credit, as other ways of borrowing, such as credit cards, can be costly when your credit is poor. If you have a 401(k) plan, a 401(k) loan may be an option, because your credit score won’t be a factor.

Can You Get a Home Equity Loan if You Have a Mortgage?

Homeowners regularly get home equity loans, also called “second mortgages,” while they are still paying off their main mortgage, also called a “first mortgage.” To qualify for a home equity loan when you already have a mortgage (which would even be another home equity loan or a HELOC), you need to have the right loan-to-value ratio. If you owe too much on your existing mortgage(s)—say, 80% of what your home is worth—you may not be able to get a home equity loan.

Is a Cash-Out Refinance Better Than a Home Equity Loan to Fund Home Improvements?

To answer this question, you’ll want to look at the interest rates and fees for each option. If rates have gone down or your credit has improved since you bought or refinanced your home, a cash-out refinance might be the most cost-effective option. However, the closing costs can be substantial and might cancel out your savings.

If home equity loan interest rates are comparable to cash-out refinance rates, and if the fees are lower (as they often are), a home equity loan might be a less costly option.

You’ll also want to consider how financing your home improvements will affect your other financial goals, such as saving for retirement, and whether or not your home improvements will increase your home’s value (in many cases they won’t).

The Bottom Line

Home equity loans are just one of many options homeowners have for borrowing money. When you either can’t qualify for one or find a lender who will offer you one on good terms, alternatives such as HELOCs, cash-out refinancing, personal loans, and shared appreciation mortgages are worth considering.