Questions to ask before borrowing from home equity

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You might be surprised to discover that you have access to an untapped asset in your home. In fact, Americans have about $1.5 trillion in home equity available to them. That money is sitting there, waiting to be unlocked.

The equity you’ve built up over time might be available to help you reach financial goals or improve your current situation. However, just because the money is there, it doesn’t mean you should tap into it. There are risks associated with getting a home equity loan or line of credit.

Here are the questions to ask before tapping home equity.

1. Am I living beyond my means?

One of the most important questions to ask yourself before tapping home equity requires you to take a hard look at your situation and where you stand. A home equity loan can help you consolidate and pay off debt, but if you haven’t fixed the problems that cause you to overspend, you could be in a worse situation.

“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.

Before you borrow against your home, make sure you’re living within your means and not setting yourself for more debt.

2. How much value will these home improvements add?

Do you plan to use the money to remodel your home? Consider the value you’re really getting from a home equity loan. Unfortunately, the vast majority of home improvements don’t increase the value of a home enough to cover their costs. This issue can be magnified if home values slide after you’ve done the remodel.

“The main risk is that any default can result in a foreclosure,” says McBride. “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.”

When making home improvements, recognize that you might not get the value you need out of your home. Borrowing a portion of the expense (say 50 percent) and paying for the rest out of savings might be a better approach to avoid getting in over your head for improvements that won’t return their value.

3. Does this home equity loan help me reach my goals?

Maybe you have other goals beyond just making home improvements. Using a home equity loan to fund a business or pay for your education can make sense if your income will rise as a result. Your home equity loan could provide you with added value down the road and be a low-cost way to improve your situation.

However, you need to be careful when tapping your equity for other financial goals. For example, using a home equity loan to pay for your child’s education may result in more income for your child, but it could hurt your own finances.

4. Will I get a tax deduction on the home equity interest?

In the past, one of the questions before tapping home equity revolved around the tax benefit. Consolidate credit cards with a home equity loan, and you could deduct the interest on your tax return. Today, that benefit doesn’t apply.

In 2017, Congress passed a federal tax law that limits the deductibility of interest you pay on a home equity loan or HELOC to money that 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 taking a home equity loan or HELOC, realize that you might not get the tax break you’re hoping for.

5. What are the ways I can tap my home’s equity?

There are three main ways to tap home equity:

  • Home equity loan: Installment loan with payments made over a set period of time.
  • Home equity line of credit (HELOC): Revolving line of credit based, similar to a credit secured by your house.
  • Cash-out mortgage refinance: Involves getting a new mortgage for more than you owe and then keeping the difference in cash.

Home equity loans typically have fixed rates and five-year to 15-year payback periods, while HELOCs generally have variable rates that start low but can climb over time. A cash-out refinance can have variable or fixed rates, and typically offer terms of 15 or 30 years. Additionally, a cash-out refinance might have a hybrid rate, where it starts out fixed but becomes variable after a few years.

6. How much can I borrow using my home’s equity?

In general, you can expect to be limited to a total loan amount (your original mortgage plus your home equity loan or HELOC) of 80 percent of your home’s value. So, if your home is worth $250,000, your total debt secured by your home probably won’t go beyond $200,000. If you still owe $150,000 on your home, that means that you’ll be limited to borrowing $50,000.

Use Bankrate’s calculator to determine how much you might be able to borrow and estimate your payments.

7. Will a home equity loan impact my credit score?

When asking questions before tapping home equity, don’t forget to consider the impact on your credit score. Because this is a loan, your payment activity will be recorded. So, if you miss payments, it could negatively impact your score, making it harder to get other loans or better interest rates.

Additionally, your debt-to-income ratio will be affected. Having the monthly payments associated with your home equity loan will take up more of your income and can affect your ability to borrow in other situations.

8. How long will it take to pay off my home equity loan?

How long you take to pay off your loan should determine how much home equity to ask for. If you can pay off what you owe in five years or less, 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, the safety of fixed rates and payments might be more attractive. Home equity loans typically offer payback periods of up to 15 years.

If you need an even longer repayment period, a cash-out refinance might fit the bill. However, cash-out refis may come with higher closing costs and they could change the rate on your primary mortgage.

9. What are the additional costs?

Weight additional costs that might come with tapping your home’s equity. You could end up paying closing costs, annual fees, home appraisal expenses and taxes. Find out the costs, how much they could add to the overall debt, and consider whether you can afford them.

10. Do I have alternatives to a home equity loan?

In some cases, it makes sense to consider other sources of money before getting a home equity loan. Here are other potential places to look:

  • Other sources of cash. Before you borrow, think about the resources you already have. Do you have savings, stuff you can sell or non-retirement investments you can liquidate? If so, using those resources could make more sense than adding to your debt level.
  • 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. You can check out personal loan rates at Bankrate.com to see what’s available.
  • Not borrowing at all. Vacations, weddings, luxuries and consumer goods should be paid for out of current income and savings. A large amount of spending isn’t important enough to justify borrowing against your home.

11. How do I qualify for a home equity loan?

Understanding the process is important if you want to get a home equity loan or HELOC designed to help you reach your goals. After you examine the pros and cons and want to move forward, it’s time to figure out if you qualify for a home equity loan. Most lenders base your qualifications on the following factors:

  • Your home equity amounts to roughly 15% to 20% of your home’s value.
  • You have an unblemished history of paying your bills on time.
  • A credit score of 620 or higher.
  • The percentage of your monthly income that goes to paying your debts (debt-to-income ratio) is limited to 36% to 43%.

It’s possible to find some lenders that are a little more flexible, though, so shop around for your options.

12. Can I get a home equity loan with bad credit?

It’s possible to get a home equity loan with bad credit if you have outstanding numbers elsewhere. For example, if your debt-to-income ratio is very low, or if you have a lot of equity in your home, you could still qualify with poor credit.

However, you will likely have a much higher interest rate if your credit is bad. Consider the cost of a higher rate before getting a bad credit home equity loan.

13. How quickly can I get my money from a home equity loan?

One of the most common questions before tapping home equity relates to how quickly the process can take place. Every lender is different, but in general, you can expect the process to take between 30 and 45 days.

Bottom line

In some cases, a home equity loan or line of credit can be a way to further financial goals and take advantage of what might be your most valuable asset. However, there are questions to ask before tapping home equity, and it’s important to carefully consider whether this is the best move and worth the risk of potentially losing your home if things don’t go as planned.

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