Tapping into the equity of your home is one method to obtain money to make home repairs, renovations or pay down high-interest debt such as credit cards.
As home values increase in your area, the amount of equity in your house also rises. The longer you pay down your mortgage, the equity in your home also increases.
Before you seek a home equity line of credit known as a HELOC or a home equity loan, determine the amount of equity you have currently. To figure out how much equity you have, subtract the amount you still owe on your mortgage from the value of your house. The difference is the amount of the equity, and part of that can be used as collateral for a loan.
Borrowing against the equity is a low-cost way to finance a new addition to the house, putting on a new roof or paying off your credit cards. One drawback is that both types of loans often have closing costs and fees similar to a standard mortgage. Closing costs on average range between 2 percent and 4 percent of the price of a property.
Under the Tax Cuts and Jobs Act of 2017, borrowers can deduct the interest paid on HELOCs and home equity loans if they use the funds to buy, build or improve the home that acts as collateral for the loan.
What is a home equity loan?
A home equity loan uses your home as collateral and is often called a “second mortgage.” The advantage of a home equity loan is that the homeowner receives a lump sum at a fixed interest rate. If interest rates rise during the term of the loan, a consumer does not have to budget for a larger monthly payment.
A home equity loan typically has a term of five to 20 years, which is shorter than a first mortgage of 30 years. The amount you can borrow is often limited to 80 percent of the equity of the home.
Consumers obtain home equity loans usually to make major repairs or renovations such as adding a new room, gutting and remodeling a kitchen or bathroom or updating it. Another common use is to use the money to pay off credit cards with high interest rates.
“A fixed rate home equity loan is best for debt consolidation, rather than the variable rate and open-ended home equity line of credit,” says Greg McBride, CFA, chief financial analyst for Bankrate.
“However, many large lenders no longer even offer the fixed rate home equity loan as the home equity line has always been the dominant product in the market.”
Use Bankrate’s home equity loan rates tables to get the most current rates.
What is a HELOC?
A HELOC is similar to a credit card because it has an extended draw period. The average is 10 years, which means a homeowner can borrow money as it is needed for repairs or renovations. Borrowers can delay repayments and borrow as much or as little as they need to just like a credit card. They can pay it back at the monthly minimum or in lump sums.
Homeowners who are facing several remodeling projects with different lengths, ranging from adding a new stove to adding a new room might find a HELOC best fits their needs.
The downside to a HELOC is that the interest rate is variable, which means monthly payments in the future can be higher or lower compared with the initial rate. The interest rate varies and is determined by several criteria, including decisions by the Federal Reserve, investor demand for Treasury notes and bonds and the banking industry.
“A home equity line of credit is better-suited to home improvement projects that will be incurred in stages, or for college tuition payments that will be paid over time, rather than the lump-sum home equity loan,” says Greg McBride, CFA, Bankrate’s chief financial analyst.
There are two type of HELOCs: one with an interest-only draw period and another with a draw period where you pay interest and principal. Paying both the interest and principal at the same time means the amount of the loan will decrease faster but your payments will be higher.
The repayment period can be up to 20 years, giving a homeowner an opportunity to renew the line of credit after it has been paid off.
Using home equity to consolidate debt, pay off credit cards
The proceeds of either a home equity loan or a home equity line of credit can be used to pay down any debt such as credit cards with high interest. The interest rates on both types of home equity loans are lower than the double-digit rates that credit card issuers charge. Using your home equity to consolidate your debt is an alternative to using personal loans or finding a lower interest rate using a balance transfer credit card.
The advantages include obtaining a lower interest rate, lowering the number of bills you have to pay each month and potentially avoiding late fees from missed payments and paying off the debt faster.
Use Bankrate’s debt consolidation guide to determine which type of loan works best for you.
The risk when you use home equity loans or a HELOC to pay off debt is that your home is the only collateral. If you were unable to make the monthly payments, your home could be foreclosed.
Another risk is that if the value of your home declines and you need to sell your home, you could end up owing more money than what your home is worth or be “upside down” on the loan. This could make selling your home more challenging.
Home equity use for other purposes
The proceeds of either a HELOC or home equity loan can be used for other purposes such as college tuition or funding other major purchases. Using them to buy discretionary items that lose value quickly such as a car, home furnishings or fund a vacation should be avoided, McBride says.