If you’re a homeowner with equity in your home, you may consider tapping into your home’s value to cover a major expense, pay off debt, or for another purpose. But you should know that if you’re unable to pay back your home equity loan, your lender has the right to file for foreclosure in order to get their money back.
Taking equity out of your home can be risky, so you need to weigh your options and make sure this is the right choice for you before moving forward. In this post, we will walk you through how to use home equity wisely to set yourself up for financial security.
The basics of how to use home equity
Home equity is the amount of value of your home that you have paid off, or that has been created through improvements and housing market changes. Say you’ve purchased a house for $250,000, with a $75,000 down payment and a mortgage loan of $175,000. Your immediate home equity is $75,000.
After several years making payments, you get your principal balance down to $150,000, and your equity grows to $100,000. Then the housing market grows favorably for you, and your home’s value increases to $300,000, but you still only owe $150,000. Your equity is now $150,000. However, you typically can’t borrow all of your accumulated equity.
So, what are the best ways to use home equity? The two most popular means are home equity loans and home equity lines of credit:
- Home equity loan. Lump sum loan that gets repaid in a flat rate installment over a set period of time, usually 5-15 years. You pay interest as well as principal on this loan.
- Home equity line of credit (HELOC). Similar to a credit card, you pull out funds as needed and pay interest only on the amount you borrow. This type of loan happens over a “draw period” of a number of years, during which you can draw funds up to the amount of your loan, followed by a repayment period.
When should you use your home equity?
You can use your home equity for several different expenses, each with its own pros and cons. Below, we’ll discuss when and how to use home equity, including their potential benefits and risks.
Home improvements. This is a smart choice if the improvements increase the value of your home. Using your house as collateral for a home equity loan generally garners you better interest rates than other types of loans. You may also be able to include the interest paid on your home equity loan for home improvements in your itemized tax deductions come tax day.
Pay for college or consolidate student loan debt. Secured debt like mortgages and home equity loans have lower interest rates than most student loans. If you’ve been dealing with student loan debt and you want to pay it off at a lower rate, consolidating your student loans into a home equity loan could end up saving you thousands over time.
Use in an emergency. You could use a HELOC as a credit card for the duration of the draw period as you recover from any number of life’s emergencies. This could give you access to as much as 85 percent of the value of your home within a matter of days. The interest rates on HELOCs are also much lower than your average credit card, but you must be smart about deploying it, as the risk of potentially losing your home can be high.
Get out of debt. You could use your equity to get out of many other kinds of debt, such as credit cards or car loans. Consolidating your high-interest debt into a home equity loan gives you a much lower interest rate, and thus more time to pay it off comfortably than a traditional consolidation loan.
Fund retirement. One way to cash out your equity for retirement is to sell your home and buy a smaller house. The remainder of the equity from the sale can be put toward your retirement fund. If you want to stay in your house, consider a reverse mortgage or home equity conversion mortgage. This mortgage is repaid once the home is sold or unused by the borrower for a year or more.
How much home equity should I take out?
Now that you know how to use home equity, you’ll need to decide how much to take out. The HELOC’s credit card-like function makes for a flexible option. If you have multiple large expenses in the immediate or near future, a home equity loan disbursed in a single lump sum could be right for you.
Another option is cash-out refinancing, wherein you take out a loan for an amount greater than what you currently owe on your mortgage. You pay off the original mortgage with that loan and receive the remainder in cash to use any way you like.
How much you take out depends on the expenses you need to cover. Weigh these needs with the load of debt you’d be taking on in order to make an informed decision.
When is it a bad idea to use home equity?
Using your home equity can be a great option in the right circumstances. It’s a bad idea, though, to take out a home equity loan if you’re unable to qualify for a low interest rate. Whether you’re using your home equity loan to consolidate debt, make home improvements, or pay for a college education, you need to compare your home equity loan interest rate with other financial products on the market.
Let’s say you want to use your home equity to fund your child’s college education and qualify for a home equity loan with a rate of 10 percent. This might not be a good idea if you can qualify for a Direct Subsidized Federal Student Loan, which has a rate of 4.53 percent in 2020.
It’s also a bad idea to dip into your equity to make particularly risky or unnecessary purchases. Large luxuries you don’t actually need are not appropriate uses of your home equity because they depreciate rapidly in value and would just set you back on your mortgage, reducing your overall equity.
It would also be extremely risky to use your equity for stock market investments. Stocks are notoriously unpredictable, and a poor choice can seriously hurt your finances—if the investment turns out poorly, you could lose your home. Generally, it’s a bad idea to cash in on your home equity for any risky investment.
Regardless of your situation and financial needs, be sure you know how to use home equity properly before you sign the paperwork. Be smart about when and for what you use your equity, though, and it can help you build even more financial security long term.
Learn how to use home equity, pay off debt, and more
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