It’s been said repeatedly that the biggest investment many Americans have is their home. The monthly payments may be seen as a forced savings plan that can increase in value over time.
Naturally, the amount you have paid on your loan adds up. You can use this equity (the value of your home minus the outstanding loan) by taking a second loan in addition to your original mortgage to make home improvements, pay off bills, or even afford a down payment on a second home.
Home equity loans
A home equity loan (also called a second mortgage) is where you take out a loan against a percentage of the equity in your home. Quite often used for home improvement – think kitchen or bathroom renovations – this loan usually comes with a fixed rate that ranges between the rates for a first mortgage and those for a personal loan. Like your mortgage, you make regular payments covering interest and principal. And as with your mortgage, if you stop paying you could lose your house.
Why take a home equity loan? The reasons for using the equity in your home is broad. You could take a loan to fix up your home and increase its value. You could buy a car. Pay off credit cards. Even go on a trip to Japan. However, just because the money is there doesn’t mean it makes financial sense to take a loan. Most people agree that using money to increase the value of your home or perhaps help your kids with tuition is a solid plan. Buying a car is more iffy, as is taking a trip. Unless you are certain that you aren’t going to run up massive credit card debt again, using your house to pay off your cards is usually frowned upon.
Dangers of a home equity loan. You can lose your house, all for that shiny new car. If you take a loan and don’t make the payments, your house is the collateral. Banks will force a sale to recoup their money.
But perhaps more common is the lack of an equity safety net in case the value of your home falls. Let’s say you have a home valued at $300,000 and you owe $220,000. You take $80,000 as a loan to make improvements. All of a sudden, the schools are redistricted (putting you in a worse high school zone) and a loud nightclub moves into the old shopping center down the street. You want to sell to keep your kids with their friends but your house value has dropped to $250,000. Here’s the problem: without a home equity loan, you would have walked away with $30,000; with the loan, you’re losing $50,000.
These numbers are simplified to make the example clear. A bank will not lend you 100% of the equity in your home. Additionally, when you sell there will be costs for the transaction.
Home equity line of credit
If you think of a home equity loan as a second mortgage, you can think of a home equity line of credit (HELOC) as a credit card. You don’t receive a set amount of money but have a credit limit that’s tied to the equity in your home, and a checkbook or credit card to use to make purchases. Like credit cards, the interest rate is variable. Unlike credit cards, this loan uses your house for collateral.
You can choose to max out your HELOC all at once or use it to supplement your other spending. Depending on your lender, the interest rate could be substantially lower than any interest you’re paying to a credit card company.
This is where the danger comes in. Many people use HELOCs to pay off their credit cards. On the surface, this is not a bad strategy. If you are paying 24.9% to a credit card company for tens of thousands of dollars, rolling that to a HELOC charging 4.5% interest makes sense. But as you’re paying down the cards, you can’t start building up more credit card debt. Remember – your house is on the line.
One other note – HELOCs often have two parts – the first period where you can spend money and will make payments on the amount you spend, and the second where you are limited to making only payments on the loan. If you have a 30-year HELOC, the first 10 may be a draw period (where you can spend) and the last 20 is a payback period. This is when variable rates can really hurt. That starter rate could easily climb if interest rates increase over the years. Also many HELOCS only require interest payments during the draw period, meaning the principal is sitting there waiting to be paid off in the future.
Should you use the equity in your home?
Planning can be the key difference between a successful home equity loan/HELOC and getting in over your head. If you have built up substantial equity, making improvements to your home can increase its value and your enjoyment of the house. If you can do this by taking only a portion of the equity, that can help protect you against decreasing home prices or a sudden transfer when you’re underwater on the loans.
Seeing a loan as an easy out or a way to purchase something you can’t really afford often leads to disaster. I mentioned above the credit card spiral that can happen if you pay off your debt using a HELOC while incurring new debt on high interest-rate credit cards. Consider other ways to pay off your cards before risking your home.
A HELOC can be a good choice if you don’t know how much money you will need over time. However, if your credit rating sinks or your house value plummets, the bank can decide to close out this loan early. You won’t have that problem with a home equity loan since it’s a one-time loan.
How to get started
Stay on top of your credit. As with any loan, make sure your credit report is in good shape and your score is top-notch. If you discover issues, get them cleared up before you contact a lender. Also make sure you’re paying your first mortgage on time every month.
Shop lenders. You do not have to work with your current mortgage company for a home equity loan. Shop around to find the best rate and lowest fees. I recommend contacting at least three lenders whenever working with a home loan.
Make sure you can afford it. When you talk with the lenders, confirm the total loan payment and work it into your budget to ensure you can make the payments. Consider upping your emergency savings before you sign the paperwork to have a little cushion in case you have other large bills hit just as you start paying off the equity loan.
Be aware of tax law changes
Before 2017 you could deduct the interest portion of your second mortgage payment from your taxes. In 2017 that was changed – unless you use that money to build or substantially improve the home that secures the loan, these payments aren’t tax deductible.
Having equity “just sitting there” can seem like an answer to all your problems. Before you decide to tap into your home, look at your options. If home equity is the best solution, make a plan both for the amount you need and the time you want to pay off the loan.
Photo by Tierra Mallorca