Top 5 reasons to use home equity

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Tapping into your home’s equity can be a good way to access cash quickly to pay for renovations or improve your financial picture, but it’s important to proceed with caution when borrowing against the roof over your head.

Common options for accessing your home’s equity include a cash-out refinance, a home equity loan or a home equity line of credit (HELOC), each of which can be used to cover everything from home improvements to debt consolidation, college costs and even emergency expenses.

What is home equity?

Home equity is the portion of your home that you’ve paid off. It’s the difference between what the home is worth and how much is still owed on your home loan. For many Americans, equity from homeownership is a key way to build personal wealth over time. As your home’s value increases over the long term and you pay down the principal on the mortgage, your equity grows.

“Equity provides many opportunities to homeowners, as it’s a great source for savings and for financing,” says Ally Home Mortgage Executive Glenn Brunker. “For example, the equity amassed in a starter home may later provide the down payment needed to purchase a larger home as a family grows and needs more space. It’s a time-tested way to build wealth.”

Home equity is typically used for big expenses and often represents a more cost-effective financing option than credit cards or personal loans with high interest rates.

How home equity works

The most common ways to access the equity in your home are a home equity line of credit (HELOC), a home equity loan and a cash-out refinance.

  • A HELOC is a variable-rate home equity loan that works like a credit card. With a HELOC, you’re given a line of credit that’s available for a predetermined time frame. During this “draw period,” which usually lasts around 10 years, you can use the money as needed. After the draw period expires, you must begin repaying whatever you borrowed over the next 10 to 20 years.
  • With a home equity loan, you get a lump sum of cash that you must begin repaying immediately. Home equity loans have fixed interest rates, meaning your payments will be the same every month.
  • Cash-out refinancing creates a new, larger mortgage on your home. You’ll use this mortgage to pay off your old one and take out the difference in cash.

In order to tap into your home’s equity through one of these options, you’ll need to go through a process that’s very similar to obtaining a mortgage. Your financial institution will determine the current value of your home, verify your personal financial profile and then coordinate closing if your application is approved.

“Lenders will consider multiple factors, including a person’s debt-to-income ratio, loan-to-value ratio, credit score, and annual income,” says Michele Hammond of Chase Private Client Home Lending. “Additionally, to determine the amount of equity in a home, a lender will employ an appraiser to determine the current market value of the home, which is based on its conditions and comparable properties in the area.”

Why use home equity?

Tapping your home equity can be a convenient, low-cost way to borrow large sums at favorable interest rates in order to pay for home repairs or debt consolidation.

However, the right type of loan depends on your specific needs and what you’re planning on using the money for.

“If you’re looking to spend as you go and only pay for what you’ve borrowed, when you’ve borrowed it, a HELOC is probably a better option,” says Sean Murphy, assistant vice president of equity lending at Navy Federal Credit Union. “But if you are looking for a fixed monthly payment and a large sum of cash up front, a home equity loan is probably the better option.”

5 ways to use a home equity loan

There are not many limits on how you can use your home equity, but there are a few good ways to make the most of your loan or line of credit:

  1. Home improvements.
  2. College costs.
  3. Debt consolidation.
  4. Emergency expenses.
  5. Long-term investments.

1. Home improvements

Home improvement is one of the most common reasons homeowners take out home equity loans or HELOCs. Besides making a home more comfortable for you, upgrades could raise the home’s value and draw more interest from prospective buyers when you sell it later on.

“Home equity is a great option to finance large projects like a kitchen renovation that will increase a home’s value over time,” says Brunker. “Many times, these investments will pay for themselves by increasing the home’s value.”

Other home improvements that yield a solid return on investment include garage and entry door replacements, a new deck, a new roof or an outdoor area addition, like a patio.

Another reason to consider a home equity loan or HELOC for home improvements is that you can deduct the interest paid if you use home equity funds to “buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the Internal Revenue Service.

Taxpayers may only deduct interest on mortgages up to $750,000. If you tap into your home equity to renovate your kitchen, you’re in the clear to deduct the interest so long as you haven’t met that limit. But if you use the money to renovate a second property (not the one you borrowed against) or for other purposes, you can’t deduct the interest on a home equity loan or HELOC.

Why use home equity for this: Using home equity for pay for home repairs is a good way to use the value of a house to potentially increase that value.

2. College costs

A home equity loan or HELOC may be a good way to fund a college education. While student loans are still the most common way to pay for an education, the use of home equity “can still be advantageous when mortgage rates are considerably lower than student loan interest rates,” says Matt Hackett, operations manager at Equity Now. “It can also extend the term of the debt, reducing the payment.”

Before tapping your home equity, however, look at all the options for student loans, including the terms and interest rates. Defaulting on a student loan will hurt your credit, but if you default on a home equity loan, you could lose your house.

Also, if you want to fund your child’s education with a home equity loan product, be sure to calculate the monthly payments during the amortization period and determine whether you can pay off this debt before retirement. If it doesn’t seem feasible, you may want to have your child take out a student loan themself, as they will have many more income-making years to repay the debt.

Why use home equity for this: Using home equity to pay for college expenses can be a good, low-interest option if you find better rates than with student loans.

3. Debt consolidation

A HELOC or home equity loan can be used to consolidate high-interest debt at a lower interest rate. Homeowners sometimes use home equity to pay off other personal debts, such as a car loan or a credit card.

“This is another very popular use of home equity as one is often able to consolidate debt at a much lower rate, over a longer term and reduce their monthly expenses significantly,” says Hackett.

The downside, however, is that you’re turning an unsecured debt, such as a credit card that is not backed by any collateral, into a secured debt – or debt that is now backed by your home. You also risk running up the credit cards again after using home equity money to pay them off, substantially increasing the amount of debt you have.

Why use home equity for this: If you have a significant amount of unsecured debt with high interest rates and you’re having trouble making the payments, it may make sense to consolidate that debt at a substantially lower interest rate, saving yourself money each month.

4. Emergency expenses

Most financial experts agree that people should have an emergency fund to cover three to six months of living expenses, but that’s simply not reality for many Americans.

If you find yourself in a costly situation — perhaps you’re out of work or have large medical bills — a home equity loan may be a smart way to stay afloat. However, this is only a viable option if you have a backup plan or know that your financial situation is temporary. Taking out a home equity loan or HELOC to cover emergency expenses can be a direct route to serious debt if you don’t have a plan in place to repay it.

Although you may feel better knowing that you could access your home equity in case of an emergency, it still makes smart financial sense to set up and start contributing to an emergency fund.

Why use home equity for this: If you have an emergency and no other means to come up with the necessary cash, tapping home equity may be the answer. However, the lengthy application process associated with accessing home equity may not be ideal for a time-sensitive emergency.

5. Long-term investments

Some homeowners use home equity to invest in the stock market or real estate, expecting the returns to exceed the cost of a home equity loan.

This has risks, though, because there are no guarantees that the stock market will perform as well as expected. Similarly, if you use home equity to invest in real estate, you can’t be certain that the investment property won’t lose its value or fail to bring in the income needed to get a return on your investment.

“It always boils down the rate of return one can achieve on a long-term investment versus the interest rate of the mortgage (or home equity line of credit),” says Hackett. “There are often long-term investments that can offer higher rates of return than the current mortgage rate, but at what risk?”

If you have your heart set on an affordable vacation home for your family and need a down payment, for example, a home equity loan may work for you. But if you want to invest in something riskier and hope to make more money, it’s better to look at other options.

Why use home equity for this: Home equity may provide a viable way to access the cash needed to finance other investments, such as a second home. But be sure to consider all of your options first and make sure that the investment is a wise one.

Things to consider

Even if you have substantial equity in your home and think it’s a good option for financing your home improvement project or consolidating debt, there are a few considerations to be aware of before tapping that equity.

The value of your home can decline

Keep in mind that there’s no guarantee that your home value will increase substantially over time. Your home may even lose value in times of economic downturn or suffer damage from extreme weather or fire.

If you decide to take out a home equity loan or HELOC and the value of your home declines, you could end up owing more on your mortgage than what your home is worth. This situation is sometimes referred to as being underwater on your mortgage.

Say, for example, that you owe $300,000 on your mortgage but the home prices in your area tanked, and now the market value of your home is just $200,000. Your mortgage would be $100,000 more than the value of your home. If your mortgage is underwater, it’s much harder to get approved for debt refinancing or a new loan with more favorable conditions.

There’s a limit to how much you can borrow

There’s also a limit to the amount you can borrow on a HELOC or home equity loan. To determine how much money you’re eligible for, lenders will calculate your LTV, or loan-to-value ratio. Even if you have $300,000 in equity, the majority of lenders will not approve you to borrow that much money.

Lenders generally allow homeowners to borrow up to 80 percent of the equity they have in their home. That number can be different from person to person, though, and depends heavily on your credit score, financial history and current income. With $300,000 in equity, expect to receive a loan for a maximum of $250,000, assuming you have good credit.

Know how not to use your home equity

Most lenders and financial advisers agree that the worst reason to tap home equity is for unnecessary personal expenses, such as an extravagant vacation or a new boat or over-the-top luxury vehicle.

While it may be tempting to spend your hard-earned money on something other than house payments, it is better to devise a savings plan to cover these fun but unnecessary expenses than to borrow from your house.

In addition, when it comes to your home equity, don’t borrow more than you need, don’t overspend and don’t put your house at risk of foreclosure for a frivolous purchase.

View home equity rates

Tap into the value you have in your home to get the funds you need.

Next steps

Even if you use your home equity to add value to your home or to better your financial position in some other way, keep in mind that if you fail to repay a home equity loan or HELOC, you could lose your home to foreclosure.

It’s a good idea to run the numbers and ensure that you can continue paying your regular mortgage on top of a new home equity loan — and that you have a solid plan for improving your finances with home equity money.

Featured image by Maskot of Getty Images.

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