Borrowing against your home equity can seem like a sound 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 put your home at risk if you can’t make the payments. And if you consistently spend more than you make, you could be squandering an important source of wealth only to end up deeper in debt in the future.
Another thing to consider: The new federal tax law limits the deductibility of the interest you pay on a home equity loan or HELOC. The law eliminates the interest deduction for equity loans unless the money is spent to “buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the IRS.
So, before you take out a home equity loan or line of credit, ask yourself these questions first.
1. Is this a Band-Aid on a bullet hole?
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.
Use Bankrate’s calculator to help you decide whether a home equity loan or HELOC is right for you.
2. How much value will this really add?
The vast majority of home improvements don’t increase the value of a home enough to cover their cost. Borrowing only a portion of the expense (say, 50 percent) 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. Paying for a child’s education should result in higher income for him or her, but it won’t increase your own.
3. How high could my payments go?
There are three ways to tap your home’s equity:
- A home equity line of credit, or HELOC.
- A home equity loan.
- A cash-out mortgage refinance.
Lines of credit typically have variable rates that start low but can climb over time. Home equity loans typically have fixed rates and five-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.
4. How long will it take to pay off the debt?
If you can pay off what you owe in five 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 five years, you’ll probably want the safety of fixed rates and payments. Home equity loans typically offer five-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.
5. What are my other options?
You should identify and investigate as many as possible. A list to get you started:
- Other sources of cash. Before you borrow, think about resources you already have that you could tap. Do you have savings, stuff you can sell or non-retirement investments you could liquidate? If so, using those resources often makes more sense than adding debt.
- Other sources of credit. Credit unions and marketplace lenders offer personal loans with fixed rates and payments. The federal government and private lenders offer education loans for students and parents. Family or friends may be willing to lend you money. Check out Bankrate.com’s personal loan offerings.
- Not borrowing at all. Vacations, weddings, luxuries and consumer goods should be paid out of current income and savings. Most spending, in fact, simply isn’t important enough to justify borrowing against your home.