Tapping your home equity can seem like a smart move. Whether you want to pay off credit cards, cover a child’s college tuition or remodel your house, home equity seems like a relatively cheap source of money.
But you’re putting your home at risk if you can’t make the payments. Plus, if you consistently spend more than you make, you could be squandering an important source of wealth only to end up further in debt down the road. Here are questions to ask before you borrow against your home.
If you’re paying off other debt, have you fixed the problems that caused you to overspend? If you’re proposing new spending, are you trying to pay for something you can’t really afford? Before you borrow against your home, make sure you’re living within your means and not setting yourself up for more debt.
The vast majority of home improvements don’t increase the value of your home enough to cover their cost. Borrowing only a portion of the expense (say, 50%) and paying for the rest out of savings is often a better approach. Using home equity to pay for your own education or to fund a business can make sense if your income will rise as a result (but of course that won’t pay off if you don’t get the degree or the business fails). Paying for a child’s education should result in higher income for her, but it won’t increase your own.
There are 3 ways to tap your home’s equity:
Lines of credit typically have variable rates that start low but can climb over time. Home equity loans typically have fixed rates and 5-year to 15-year payback periods, while cash-out refinances can have variable, fixed or hybrid rates (fixed followed by variable) and typically terms of 15 or 30 years. Figure out the worst-case scenario payment so you understand how much you might be expected to pay.
If you can pay off what you owe in 5 years or less, then a home equity line of credit may be your best bet because HELOCs are relatively cheap to set up. If paying back your debt will take you longer than 5 years, you’ll probably want the safety of fixed rates and payments. Home equity loans typically offer 5-year to 15-year payback periods.
You can get even longer payback periods and lower rates with a cash-out refinance, but refinances come with closing costs that can total hundreds or thousands of dollars, plus they change the rate on your primary mortgage.
You should identify and investigate as many as possible. A list to get you started:
After answering these questions, are you ready to shop for a home equity loan or HELOC? Compare lenders on Bankrate.com.