If you’re like most Americans, your home is your most valuable asset and your mortgage payment is almost certainly your largest monthly payment. With so much money tied up in one item, it’s important to understand the role your home plays in your overall financial picture.
Is it smart to take out a home equity loan for home improvements? Is it wise to tap equity for higher education expenses? Should you scrimp to make extra payments to principal each month?
The home equity equation has become more complex in recent times, due to deteriorating conditions in the housing market. Although homes in some regions of the country are seeing modest price appreciation, many homes have fallen in value. In the year through September 2008, the national median price for housing declined 9 percent, from $210,500 to $191,600, according to the National Association of Realtors. Naturally, under these conditions lenders have retreated from heavily marketing home equity loans.
However home equity loans are still available. Getting a loan in this new housing landscape depends on several factors, including your particular financial situation, tighter credit issuing standards and the less lofty real estate appraisals, says John Pallaria, a Certified Financial Planner and adjunct professor in Boston University’s CFP Program. Here Pallaria takes a look at possible uses of home equity.
- Heading to retirement.
- Building home equity.
- Need a loan.
- Ready to remodel.
- Buying a car.
- Financing an education.
Heading to retirement
You always want to be debt free going into retirement,” Pallaria says. As a homeowner, any equity you have in your home is similar to money in the bank and can only help you when you retire. That said, think about these three things before funneling money into your home:
1. Pay down loans with highest interest rates first. While it’s important to look for the highest rate of return when investing, when repaying debt, work to eliminate your highest rates first. Pallaria recommends paying off all credit cards on which you carry a balance. Once you pay them off, use your funds to pay the principal off on other types of loans, such as car loans.
2. Fully fund 401(k)s. Always take advantage of employer matching contributions. In fact, Pallaria recommends maxing out your retirement plan before funneling extra money into building home equity. “Leading up to retirement, fully funding your employer-sponsored retirement plans and any IRAs would be an important consideration,” he says. For 2008, IRS rules allow you to contribute up to $15,500 per year to your 401(k) account — $20,500 if you’re over 50 years old and making catchup contributions.
3. Defer prioritizing home equity if home values depreciating. If the market in your area is sliding, Pallaria suggests homeowners exercise caution and put less emphasis on tapping home equity. Many people count on the equity in their home to help sustain them in retirement, but a house is not always the high-yield investment it first appears to be.
“If home values have gone down and now you’re tapping into the equity, a) how much are you borrowing and, b) while in retirement do you have other sources to pay back that loan? I think that’s a very important component here.”
Building home equity
Looking forward to the mortgage-burning party but finding it tough to set aside extra funds? Follow these tried-and-true strategies to pay off your mortgage faster and to build home equity:
- Raises. Set aside a portion or the full amount of any raise you receive for paying down mortgage or equity loans.
- Extra payment. Send an extra payment to your lender directly at the beginning of month. Or apply any money left in your checking account at the end of the month to your loan’s principal.
- Shift funds. If you’ve been paying down credit cards, shift the money to your mortgage payment after you pay off your cards. You’re already used to paying out that money anyway.
Need a loan
If you know you need to borrow, home equity loans can be an excellent way to satisfy cash flow needs, says Pallaria, who considers their tax deductibility an important part of the equation. But he also cautions that it’s important to weigh all your options carefully.
Even if you have a decent amount of equity built up, you’re likely to find it tough to get a home equity loan if you don’t fit today’s mold of eligible borrowers because lenders are clamping down on credit and underwriting standards.
“I think people certainly need to have credit scores north of 700 or maybe even north of 750 these days to really be able to secure a home equity loan, because having equity is one side of the story, being able to pay it back is the other,” he says.
When borrowing, if you have the option of withdrawing money from an investment portfolio, getting a personal loan or dipping into your home equity, compare the net rates of return first. With a home equity loan tax deduction, a 7 percent loan might only cost 5 percent. If you expect your investment portfolio to return better than 5 percent, it might be better to the leave that money untouched.
Beware of taking withdrawals from tax-favorable retirement accounts since that may result in tax consequences, plus the possibility of stiff penalties for early withdrawals.
If you decide to go with a home equity loan, make sure to file the long Form 1040 at tax time. “For folks who aren’t itemizing, they’re basically missing out on a deduction,” Pallaria says.
Ready to remodel
Although home improvements generally increase the value of your home, the return isn’t always dollar-for-dollar. However, some improvements are consistent winners. “Statistics show that kitchens and baths have the best return on the dollar that is spent renovating those items,” Pallaria says. His advice is to keep in mind that not everybody has the same taste. The next owner may not want to pay for your koi pond or a garage that’s been transformed into a dance studio.
To maximize resale potential, any renovations should be conservative, says Pallaria. “If they’re going to renovate a basement or make more living space, being on the conservative side of how it’s built, how it’s structured and how it’s decorated is going to be important to people that may be prospective buyers of the house.”
Keep an eye on the bottom line and weigh decisions in terms of livability. The benefit of borrowing equity for home improvement as compared to other loans is the tax advantage available to anyone who itemizes his or her returns.
Buying a car
Although home equity borrowing to purchase a vehicle usually affords the luxury of lower payments, Pallaria points out that this turns a five-year car loan into a 15-year home equity loan.
“I would say if you’re considering using a home equity loan to buy a car, it’s not necessarily a bad thing, but stretching it out longer than you need to isn’t the best use of that strategy.”
He adds that it’s best to make the repayment schedule “apples to apples.” In other words, if you’re going to purchase a car using a home equity loan, try to time your payments so the car is paid off within 60 months or less. Of course, the interest on a home equity loan is generally tax deductible if you itemize. Compare costs using Bankrate’s auto loan calculator.
Financing an education
Many people use home equity loans to pay for educational expenses. However, Pallaria says college 529 plans are by far the best way to save for your child’s college education because not only do earnings grow tax free, but the distributions are tax-exempt when used for qualified educational expenses. Plus grandparents, aunts and even the child can contribute.
Students who are unable to take advantage of a college 529 plan may want to consider federal student loans, or as a last resort, a loan through the private sector. Pallaria cautions that interest rates on private student loans can be high. With interest rates on home equity loans climbing, it’s important to consider the consequences of borrowing with both types of loans.
“You need to look at what the interest rate environment is: Is it going to change? What’s the payback period? Are equity rates up or down?” The good news — interest on both types of loans is tax deductible within certain guidelines.
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