Borrowing home equity: Rules of the road
Borrowing against your home equity can be an inexpensive way to finance home improvements, big purchases or even college educations.
Or, it can be a disaster that will cost you far more than you expect. Home-equity borrowing dragged millions of homeowners underwater during the real estate recession, trapping people in homes worth less than they owed and vastly increasing their odds of foreclosure.
Real estate research firm CoreLogic found in 2011 that 38 percent of homeowners who borrowed against their equity owed more on their houses than they were worth, compared with 18 percent of borrowers who didn’t have home equity loans or lines of credit.
Equity lending has returned
Now, a few years later, home values in many areas are rising and banks are once again willing to extend credit. Lenders approved $13 billion in home equity loans and lines of credit in the first quarter of 2014, according to industry newsletter Inside Mortgage Finance. That pales in comparison to the peak of $113 billion in the third quarter of 2006, but it’s still up 8 percent from a year earlier.
If you’re thinking of borrowing against your home equity, here’s what you need to know.
You need to have equity to borrow from equity
The days of being able to borrow 100 percent or more of your home’s worth are long gone. A few lenders will let you borrow up to 95 percent of your home equity, including your primary mortgage, but most will limit you to 80 percent or 85 percent of your home’s value. Lenders typically require decent credit and sufficient income as well.
Smart homeowners don’t borrow more than 80 percent to give themselves a cushion against emergencies or dropping home values, says Paul Golden, spokesman for the Denver-based nonprofit National Endowment for Financial Education.
Your payments could rise
Most home equity borrowing consists of lines of credit, or HELOCs, which have variable interest rates and payments that cover only interest in the early years. Your payment could shoot up if rates rise or when you’re required to begin paying principal.
Monthly payments on a HELOC, during and after the draw period
The monthly payments rise sharply when the amortization period begins on a home equity line of credit. These payment amounts assume a 20-year repayment period, with the interest rate rising from 3.25 percent to 5 percent. Payments would be more with a higher interest rate or a shorter repayment period.
|Amount owed||Interest-only during draw period at 3.25%||Interest plus principal during amortization period at 5%|
If you prefer fixed rates and payments, look for a home equity loan instead of a line of credit. Remember, the loans are secured by your house, so if you can’t make your payments, you could lose your home. Even if you opt for a line of credit, you should make more than the minimum payments to ensure you’re paying down what you owe, says financial planner Delia Fernandez of Los Alamitos, California.
You should borrow carefully
Financial planners generally discourage their clients from borrowing for vacations and other purchases that don’t have lasting financial value. Borrowing to pay off other debt is problematic, since many people don’t fix the financial habits that caused them to run up the debt in the first place, planners say.
“If the individual is not ready to get rid of personal debt or hasn’t built the right habits to avoid spending on unnecessary purchases, the HELOC contributes” to getting further into debt, says Los Angeles financial planner Louis Barajas, author of several financial books including, “My Street Money.”
Fernandez is far more likely to recommend home equity borrowing to preserve or enhance a home’s value, since many people don’t have sufficient savings to cover major home repairs or remodels.
“Large repairs such as a sewer break or the heating and air conditioning system going on the blink can upset even the best budget,” Fernandez says.
Tie your debt to the life of what you’re buying
Most home-equity borrowing should be paid off fast to limit the total cost of the loan or line of credit, Golden says. Paying down the principal of a HELOC has the added advantage of freeing up credit for future use.
You can take a bit longer for remodels that add value to your home, Fernandez says.
“If you used your HELOC to remodel your kitchen, it makes sense to pay that off over a long period of time, perhaps 10 to 15 years, since it’s a major capital investment in your home,” Fernandez says.