Home values have increased considerably in recent years in many areas, giving homeowners an avenue to tap their home’s equity to make renovations or otherwise improve their overall financial picture.
While this can be a good way to access cash quickly, it’s important to proceed with caution and have a good reason for doing so. After all, you’re borrowing against the roof over your head.
So before you get a cash-out refinance, home equity loan or home equity line of credit (HELOC), think about how you plan to use the money. The most common ways to spend home equity are for home improvements, debt consolidation, college costs, emergency expenses and 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 to enjoy, upgrades could raise the home’s value and draw more interest from prospective buyers when you sell it later on.
But if you plan to sell the house, be mindful of the types of home improvements you make. A common mistake is using equity to add features that don’t increase the value of the home, says Rick Sharga, executive vice president of Carrington Mortgage Holdings in Irvine, California.
“If you’re thinking about selling your house soon, you want to be cautious about how much you spend on what, because there’s a limit to how much you can get over the market value on a house,” Sharga says. “Most real estate folks will say new paint and carpeting, and maybe some upgrades to the kitchen or bathrooms help the value of the house.”
Other home improvements that yield the best return on investment include garage and entry door replacements, a new deck, a new roof or outdoor area, like a patio.
Another reason to consider a home equity loan or HELOC for home improvements is that you can deduct the interest paid. While homeowners were previously allowed to deduct interest on a HELOC or home equity loan up to $100,000 — regardless of how the funds were used — the new tax law has limited the use of 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, down from the previous limit of $1 million. 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.
2. College costs
A home equity loan or HELOC can be a good way to fund a college education because the interest rate might be lower than that of a student loan. As of October 2019, the average home equity loan interest rate was about 5.85%, compared to a fixed interest rate of 4.53% for undergraduate student loans and 6.08% for graduate school loans.
“Paying for education to potentially put yourself in a higher income bracket — that’s a huge positive for using home equity,” says George Pantelaras, director of consumer direct/internet production at Planet Home Lending in Tampa, Florida.
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 as they will have many more income-making years to repay the debt.
3. Debt consolidation
A HELOC or home equity loan can be used to consolidate high-interest debts to 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 can be dangerous, however, if the homeowner runs up the credit cards again after using home equity money to pay them off.
“If you’re planning on tapping home equity to pay off debt, there better be a good management plan in place,” Pantelaras says.
Also, there are closing costs on a home equity loan or HELOC, so you need to look at how much it will cost overall to borrow against your equity.
“You’re paying a lot of money upfront to pay off the other debt, so it’s got to make financial sense,” Pantelaras says.
While you may be able to manage the monthly payment during a HELOC’s draw period — the first few years when you borrow as you like and pay only the interest — you might not be able to afford the new payments during the amortization period when you pay off the interest and principal of the loan. Calculate the total cost and then take a serious look at your financial situation before putting your house in jeopardy.
If you do opt to use a home equity loan or HELOC to consolidate debt, you should make sure to have a solid financial plan in place to ensure that you can keep with your daily expenses and your loan payments.
4. Emergency expenses
Most financial experts agree that people should have an emergency fund to cover three to six months of living expenses, but a recent Bankrate survey found that most Americans couldn’t cover a $1,000 emergency with their savings funds.
If you suddenly 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 financial 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.
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 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 the investment property won’t lose its value or bring in the income needed to get a return on your investment.
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.
“People tend to sometimes overvalue a property they want to invest in or underestimate the costs involved,” Sharga says. “It’s really about financial management and whether it makes sense to start with other investors or real estate professionals.”
Things to consider
The value of your home can decline
Although home values have been increasing steadily over the last few years, there is no guarantee that the trend will continue. Home values diminished significantly during the 2008 recession, when many people were already struggling to pay their mortgage. It’s also possible that the housing market could crash unexpectedly, or that your home could be destroyed by extreme weather or fire.
If you decide to take out a home equity loan or HELOC and the value of your home declines, it’s important to know that 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
It’s important to remember that there is 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 equity. Even if you have $300,000 in equity, though, the majority of lenders will not approve you to borrow much money.
Lenders generally allow homeowners to borrow up to 80% 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 the house payments, or to get some immediate joy out of all the ones that you’ve made, it is better to devise a savings plan to cover these fun but unnecessary expenses than to borrow from your house.
“These were the things people got in trouble with during the housing market boom,” Sharga says. “They used their house as an ATM.”
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.
The bottom line
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. Run the numbers to ensure 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.
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