This article was originally published on Bankrate.com.
Tapping into your home’s equity can be beneficial in many ways. You can access the cash needed to cover significant expenses, improve your financial situation or for whatever else you see fit.
Still, it’s important to proceed with caution when borrowing against the roof over your head—failure to make timely payments can result in foreclosure
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 mortgage. For many, 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 Glenn Brunker, president at Ally Home. “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.
The most common ways to access the equity in your home are a HELOC, a home equity loan and a cash-out refinance.
To tap into your home’s equity through one of these options, you’ll need to go through a process similar to obtaining a mortgage. You can apply through a bank, credit union, online lender or another financial institution that offers these home equity products.
“Lenders will consider multiple factors, including a person’s debt-to-income ratio, loan-to-value ratio, credit score, and annual income,” said Michele Hammond, senior home lending advisor at 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.”
Tapping your home equity can be a convenient, low-cost way to borrow large sums at favorable interest rates to pay for home repairs or debt consolidation.
However, the right type of loan depends on your needs and what you plan to use 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.”
There are few 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.
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,” Brunker says. “Many times, these investments will pay for themselves by increasing the home’s value.”
Another reason to consider a home equity loan or HELOC for home improvements is that you can deduct the interest paid on home equity loans of up to $750,000 if you use the loan funds to buy, build or substantially improve the home that secures the loan.
Why use home equity for this: You can use the value of your home to increase that value.
Why you should skip it: The monthly payments on a home equity loan or HELOC coupled with your monthly mortgage payments will stretch your budget too thin.
A home equity loan or HELOC may be a good way to fund a college education if your lender allows it. 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 mortgage lender Equity Now. “It can also extend the term of the debt, reducing the payment.”
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 this debt off 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.
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.
Why you should skip it: Taking out home equity could be riskier. If you default on your loan, you could lose your home.
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 car loans or credit cards.
“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,” Hackett says.
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.
Why you should skip it: You’re turning an unsecured debt, such as a credit card that is not backed by any collateral, into secured debt, or debt that is now backed by your home. If you default on your loan, you could lose your house. If you fall behind on credit card payments, you don’t lose anything (although your credit score will tank). You also risk running up the credit cards again after using home equity money to pay them off, substantially increasing your debt.
Most financial experts agree that you should have an emergency fund to cover three to six months of living expenses, but that’s not the 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 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.
Why you should skip it: The lengthy application process associated with accessing home equity may not be ideal for a time-sensitive emergency.
For some couples, it might make sense to take out a home equity loan or HELOC to cover wedding expenses. According to The Knot’s Real Weddings study, the average cost of a wedding in 2021 was $28,000, up from $19,000 in 2020. This doesn’t even include the average cost of the honeymoon.
To pay for this special life event, some couples turn to wedding loans, or personal loans used for weddings. However, the interest rates on these loans are typically higher than interest rates for home equity loans and HELOCs because they are unsecured—not tied to an asset.
Although tapping your home equity could save you money on interest, be careful not to take out more than you need. By having family members contribute or cutting costs on some wedding expenses, you might be able to reduce the cost of your dream wedding.
Why use home equity for this: Using home equity to pay for wedding expenses can be cheaper than taking out a wedding loan.
Why you should skip it: You can lessen how much you borrow by adjusting your wedding celebration, saving up for the big day, and asking family and friends for contributions instead of gifts.
Some business owners use their home equity to grow their businesses. If you have a business that requires more capital to grow, you might be able to save money on interest by taking equity out of your home instead of taking out a business loan.
Before you commit to taking this action, run the numbers on your business. As with using your home equity to purchase investments, a return on investment in a business isn’t guaranteed.
Why use home equity for this: You might be able to borrow money at a lower interest rate with a home equity loan than with a small-business loan.
Why you should skip it: If you haven’t tested your business, your plan could fail and you’d still need to make payments on what you borrow—regardless of lack of earnings.
Some career professionals invest thousands of dollars in their professional development to stay abreast of industry trends and unlock the door to higher earnings. Continuing education options include professional development courses, boot camps and advanced degrees, all of which can be pricey and warrant using a home equity loan or proceeds from a HELOC to avoid having to dip into your savings.
Why use home equity for this: Some continuing education and boot camp programs cost several thousands of dollars, and advanced degrees are even pricier. So, it may not be worthwhile to continue putting off your professional development if they’ll help you position yourself for more lucrative career opportunities soon.
Why you should skip it: Acquiring professional designations can improve your career, but it’s worth consulting with your employer before pulling equity out of your home. They may offer financial assistance to employees looking to further their education or level up their industry knowledge.
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.
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 fire or extreme weather.
If you take out a home equity loan or HELOC and the value of your home declines, you could end up owing more between the loan and your mortgage than 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, getting approved for debt refinancing or a new loan with more favorable conditions is much harder.
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 loan-to-value ratio or LTV. Even if you have $300,000 in equity, most lenders will not let you borrow that much money.
Lenders generally allow homeowners to borrow up to 80% to 85% of the value of their homes, minus existing mortgage balances. That number can differ from person to person, though, and depends heavily on your credit score, financial history and current income.
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 an over-the-top luxury vehicle.
While spending your hard-earned money on something other than house payments may be tempting, 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.
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 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.
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This article was originally published on Bankrate.com.