If you’re a homeowner with equity in your home, you may be considering tapping into your home’s value to cover a major expense, pay off debt, or use 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 and success. We’ll also discuss when using your home equity could be a bad idea.
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. This makes your immediate home equity $75,000. After a number of years of 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.
Once you’ve built up some equity, the question is how to use home equity to your advantage. The two most popular means to use your equity are home equity loans and home equity lines of credit:
- Home equity loan: a 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 you only pay interest 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?
There are a number of different expenses you can use your home equity for, and they each come with their specific pros and cons. Below we discuss some of these common uses for home equity, as well as their potential benefits and risks involved.
Pay for Home Improvements
One of the best things you can do with your equity is to make improvements on your home. This is a smart choice if the improvements would increase the value of your home. Using your house as collateral in 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, so if you’re planning to go back to college or you want to help pay for your child’s college education a home equity loan could be a good choice.
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. Learn more about the pros and cons of using equity to pay down student debt.
Use in an Emergency
You could essentially 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% of the value of your home within a matter of days, a definite boon when you’re in a tough spot. The interest rates on HELOCs are also much lower than your average credit card. But, as with all of these use cases, you must be smart about deploying it, as the risk of potentially losing your home is quite high.
Get Out of Debt
You could use your equity to get out of many other kinds of debt, such as from 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. Learn how to use your home equity to pay off debts, as well as the risks involved.
One way to cash out your equity for retirement is to sell your home and buy a smaller house, or something in a cheaper city. The remainder of the equity you cash out from the sale to be put towards your retirement fund.
If you want to stay in your house, though, you can look into what’s called a reverse mortgage or home equity conversion mortgage. An FHA-insured loan for borrowers over 62, this mortgage is repaid once the home is sold or unused by the borrower for a year or more. It can never exceed the value of the home.
How Much Home Equity Should I Take Out?
Now you’ve decided to take out some equity, but how do you decide how much to take out and what kind? This decision is completely centered around the budget needed at hand.
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 up front in a single lump sum, could be right for you.
Cash-out refinancing is an option wherein you take out a loan for an amount greater than what you currently owe on your mortgage. With that loan you pay off the original mortgage and receive the remainder in cash to use as you will.
Ultimately how much you take out depends on the expenses you need to cover. Weigh that budget need with the load of debt you’d be taking on and make an informed decision. Use the chart below to help you determine which type of home equity cash out best suits your situation.
|Type||When to use|
|Home equity loan||For a one-time large expense, or foreseeable large expenses within one year or so, such as renovating your home|
|Home equity line of credit||For a series of expenses over a longer span of time, college tuition, for example, or a series of home improvements rather than a large one-time renovation|
|Cash-out refinance||When paying off high-interest credit cards, or another load of debt with high interest rates|
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%. This might not be a good idea if you can qualify for a Direct Subsidized Federal Student Loan, which in 2019 has a rate of 5.05%.
When using your home equity, it’s crucial to do your homework and compare all of your options. Sometimes putting your home at risk is not worth the money, rate, and terms, you’ll get.
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. These kinds of purchases depreciate rapidly in value, and would just set you back on paying off your mortgage, reducing your overall equity. Some examples of these types of purchases include:
- Luxury vehicles
- First-class airfare
- Extravagant weddings or parties
It would also be extremely risky to use your equity for stock market investments. Stocks are notoriously unpredictable, and a poor choice can tank you financially. Since the collateral in this case is your house, 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. Opening a new restaurant in a saturated or untested market, for example, would be better suited with other types of loans.
How to Use Your Home Equity: The Bottom Line
In conclusion, it is key to remember that using home equity is smart when it can help you to raise the value of your home, or if you are certain of the return on your investment. Risky investments or frivolous purchases could get you in hot water, and potentially cause you to lose your home. Be smart about when and for what you use your equity, though, and it can help you build even more financial security long term.