Tapping home equity is a sound financial decision if the circumstances are right. It can be an effective way to accomplish goals such as paying off higher-interest credit cards, covering a child’s college tuition or remodeling your house.
“Home equity borrowing, when prudently utilized, can be a low-cost source of funds for homeowners that are equity-rich but cash-poor,” says Greg McBride, CFA, Bankrate’s chief financial analyst.
But you put your home at risk if you can’t make the loan payments. And if you consistently spend more than you make, you could endanger an important asset and go deeper in debt.
American homeowners have about $1.5 trillion in home equity available to them, but they’re not rushing to apply for home equity loans.
“Americans are sitting on a record amount of home equity but are reluctant to tap it as memories of the housing bust remain fresh,” says McBride.
“The main risk is that any default can result in a foreclosure. But even if you keep current with the payments you can still find yourself owing more than your home is worth should home values slide.”
Another thing to consider: The new federal tax law that was passed in 2017 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 used to “buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the IRS.
“Higher rates and changes to the tax deductibility of the interest have removed some of the appeal that existed a few years ago,” says McBride.
Before you take out a home equity loan or line of credit, here are some home equity loan FAQs to consider.
1. Is this a Band-Aid on a gaping 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 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 find your home’s estimated value and how much equity you might be able to borrow.
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 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 education or to fund a business can make sense if your income will rise as a result. Using it to pay for a child’s education may result in more income for your child, but it could hurt your finances.
3. How high could my payments go, and how much home equity can I ask for?
There are three ways to tap home equity:
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.
Home equity loans will usually max out at about 80% of the value of your home. 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 loan?
How long you take to pay it off should determine how much home equity to ask for. 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 cash-out refis may come with higher closing costs and they change the rate on your primary mortgage.
5. What are my other options?
You should identify and investigate as many alternative sources of money as possible, such as:
- 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 personal loan rates at Bankrate.com.
- Not borrowing at all. Vacations, weddings, luxuries and consumer goods should be paid for out of current income and savings. Most spending, in fact, simply isn’t important enough to justify borrowing against your home.
6. How do I qualify for a home equity loan?
If you have examined the pros and cons of taking out a home equity loan and still want to do it, your next question should be whether you qualify. Most lenders will base your qualifications on a number of factors. These are:
- The equity in your home must be roughly 15% to 20% of the home’s value.
- You have an unblemished history of paying your bills on time.
- Your credit score is 620 or higher.
- The percentage of your income that goes to paying your debts, known as your debt-to-income ratio, must be no higher than 36% to 43%, although some lenders will allow a slightly higher ratio.
7. Can I get a home equity loan with bad credit?
If you have bad credit, you can certainly offset that with outstanding numbers elsewhere. For example, your debt-to-income ratio could be very low, or you could have a lot of equity in your home.
Something to think about, however: A bad credit score will not get you the best interest rate.
8. How soon can I get a home equity loan?
Each lender has a different wait time. However, if you have filed all the paperwork, you could see the loan approved in as few as 30 to 45 days.