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One of the significant advantages of home ownership is that as your home’s value appreciates and you pay down what you owe, you also build equity in your home. That amount is a reward for investing in an appreciating asset.
If you encounter major expenses of any kind, having equity allows you to use a portion of it to satisfy your debts. That can be a lifesaver if you have a major medical expense, need to pay college tuition, or consolidate debts, among other reasons.
Tapping into home equity is a smarter move in some cases more than others. You’re putting up your home as collateral, and if you misuse the money, you could lose your most valuable asset if you’re not careful.
Tapping into home equity requires discipline to make payments as required to avoid a financial catastrophe.
Two Ways to Tap Home Equity
You can borrow against the equity in your home through a home equity loan or a home equity line of credit (HELOC). They give you access to cash you can use for any reason, but they are much different in how they’re executed.
A home equity loan is for a specific amount for a fixed term at a fixed interest rate, with principal and interest paid monthly. Five years is the most common, though they can go for as long as 30 years for maximum flexibility, although you’ll pay a lot more in interest over the longer term.
Also, note that home equity loan payments are in addition to your usual mortgage payment.
A home equity loan is a single lump-sum draw against the equity in your home. It can be a good source for major projects and one-time expenditures.
HELOCs create a line of credit, much like a credit card you have access to, but you decide when and how much of that amount you’re approved for that you want to use and when. You use what you need when you want it and only pay interest on the amount you draw for a draw period.
When that draw period ends, you’ll make principal and interest payments like you would for a home equity loan.
HELOCs are adjustable-rate loans that begin with a lower interest rate than home equity loans. Payments and interest amounts rise or fall depending on the movements of a benchmark.
Good Reasons to Use Home Equity
Home Remodeling or Repairs
Experts agree that using home equity to increase the value of your home is one of the best moves you can make in using these types of funds. You’re investing in an appreciating asset and protecting or enhancing your home’s value.
When your home needs costly repairs such as a new roof, kitchen, or bath, or you’re finishing a basement for added family or recreation, use of home equity for such improvements to the asset is common and a reasonable use of savings. If you sell your home down the road, you’ll likely see most of your home equity investment returned as part of the sales proceeds.
Losing a job, having unexpected medical costs, divorce, or needing funds for a family member’s long-term care are common reasons people tap loans and HELOCs. It’s the lowest interest way to incur a large unanticipated debt you can spread out for the longest period.
This is a little more tricky because while you can consolidate debt at a lower interest rate than you’ll typically pay for credit cards and other revolving credit lines, there is always the temptation to tap those lines again. That is counterbalanced by interest in a home equity loan, which is also generally tax deductible for added savings.
It can create a downward spiral to the point that you’re making home equity loan repayments, and you’re now saddled with all the other old debts you tried to retire with the loan. The key here is exceptional discipline and having a master plan to retire your debt that you don’t deviate from under any circumstances.
Start a Business
Many businesses tap into home equity to fund their passion, moving from a small start-up to a full-fledged business that can pay dividends hundreds of times beyond the risk of using a home as collateral.
Many people with existing successful businesses also use home equity loans to expand their businesses.
This is another common use of home equity loans. Instead of investing in an asset like a car or a home, you’re investing in your family members. It’s best to check first to see if you can do better with student loans at a lower rate, but otherwise, this is generally accepted as a good use of funds toward an appreciating asset: your child’s future.
If you have a choice, a HELOC is more appropriate than a loan. HELOCs are tailor-made for expenses incurred in installments over a long period. You withdraw what you need for a semester’s tuition, and you’ll only incur interest on that particular amount.
» MORE: See today’s refinance rates
Bad Reasons to Use Home Equity
A New Car or Boat
Using home equity for boats, cars, vacations, and jewelry results in investing in a depreciating asset in most cases. That flies in the face of the conventional wisdom of putting your home at risk for a bad return on using your funds.
Most debt, including home equity, should be used to acquire assets that will appreciate or maintain value or to rehabilitate health, family, or financial health.
To Help Solve Monthly Cash Flow Problems
It’s generally not a good idea to resort to a home equity loan if you’re simply using the money to help resolve day-to-day shortfalls in your household or living budget. If you’re at this point, you already have financial stress, which will only worsen in the long run.
That’s compounded by the risk of losing your home when you put it up as collateral.
Unlike defaulting on a credit card with penalties amounting to late fees and a lower credit score, defaulting on a home equity loan or HELOC could allow your lender to foreclose on it.
If You’re Only Banking That Your Home’s Value Will Continue to Increase
Home values have skyrocketed in recent years, but all markets have ups and downs. If you’re not careful, you could time your home loan to coincide with market rates on the rise, an economic recession, or several other scenarios that could cause your home value to stagnate or even lose value.
That could create a situation where you’re upside down on your home loans, owing more on your residence than it is worth. That could be a real problem if you try to sell your home.
If you have a HELOC and the value of your home tumbles dramatically, your lender could cap your balance or freeze access, meaning you would no longer be able to withdraw funds from it.
HELOCs generally have adjustable rates, meaning payments increase as interest rates rise, potentially putting a squeeze on your finances. When you’re only paying the minimum early in the loan, a rate increase could make payments unmanageable later.
Your Credit Score Can Drop
Adding a large home equity loan can negatively impact your credit score. That could make it harder to qualify for other loans and result in worse terms for major purchases such as buying a car.
Over time, demonstrating a consistent ability to pay your loan on time will reverse this trend by showing you have a good handle on your monthly debts, but in the short term, you’re likely to take a hit.
Borrowing More Than You Need
You’re putting your home at risk; the bigger the amount you loan against it, the more risk involved. With leftover money in your pocket, there’s a greater temptation to misuse the funds, further creating the possibility that your wants will outstrip your ability to pay back the loan with payments you can afford.
Weigh your options carefully, and when you get your loan, create a budget and stick to it.
If you opt for a HELOC, ensure that the budget includes interest payments and some of the principal at the outset. It’s better to get ahead of the curve as quickly as possible, which can save you money with a smaller interest charge and less impact when the draw period ends and you must start repaying the loan in earnest.