Leveraging the equity in your home can be a savvy financial move or a step backward.
Pros & cons
- When borrowing makes sense.
- Advantages of equity loans.
- Pitfalls of tapping equity.
- Try something different.
Scenarios when borrowing might make senseYou have erratic or hard-to-prove income: Because home equity borrowing is a secured loan and a number of lenders still base loan approval on credit score alone, you have a better chance of approval, providing your credit score is good. Plus a line of credit can act as backup between income infusions, usually at a lower rate than credit cards.
Your child is applying for financial aid at a private school: Need-based student aid decisions are determined partially on your assets, including primary residences whereas credit card debt is not reflected. Consolidating credit card or other outstanding debt using home equity dissipates the value of that asset, more accurately reflecting your financial picture. NOTE: This does not apply to FAFSA, the Free Application for Federal Student Aid.
You need to bridge a short financial gap: If you have a realistic view of your financial picture, and have determined you have the means and financial discipline to pay down the loan, there are benefits that could make home equity borrowing the smartest choice.
Advantages of home equity loansTax-deductible interest: Interest on the first $100,000 is tax-deductible, regardless of use. Additional interest may be tax-deductible if used for a business expense or another allowable purpose. Remember, you must itemize.
Lower rates than unsecured loans: Lenders carry lower risk holding your home as collateral, translating into lower interest rates than offered with unsecured loans.
Pitfalls of home equity loansNot everyone can deduct interest. You must file an itemized tax return to claim the tax deduction on the interest paid. Your tax savings isn't dollar-for-dollar, says Katie Porter, associate professor of law at the University of Iowa and mortgage bankruptcy researcher. "For every dollar you get to deduct, you're reducing your income, which saves you -- depending on your tax bracket -- 20-25 percent on your taxes."
Shouldn't be used in place of making tough financial decisions: Taking on debt when money is tight is rarely a good idea. "It might be better to sell your car and get a cheaper one," Porter says, "than to put your house at risk."