There are advertisements almost daily on radio, television and the Internet about what a great deal it is to use the equity in your home to consolidate debt, make home improvements, pay for a vacation, or finance an education.
Many of these make it sound almost too good to be true. The fact is, if you must have debt, home equity loans or lines of credit can be a good choice, but not always.
Here are some facts about the differences between different home equity lending products and when it is or is not such a good idea to tap into your home’s equity.
Understanding Home Equity
How you get home equity
First of all, you have equity in your home as soon as you owe less on it than its current market value. If you made a down payment of ten to twenty percent of the sale price, you are starting out with equity in your home. If you bought a “fixer-upper” and then did the work yourself to improve the appearance and value of your home, then you have created more equity or added to its overall value with “sweat equity.”
Home price appreciation creates equity
In general, in a normal market, a home’s value also increases every year. By the time you have owned your home several years, it may be worth more than it was when you bought it. That is a great deal and the idea scenario in a good, strong economy. The only problem is you can’t always predict economic conditions.
How much you may borrow
Most lenders will allow you to borrow against the value of your home when you have at least 20 percent equity, or in other words let you borrow up to 80 percent of the home’s value, minus what is owed on the first mortgage.
For example, if you have a $100,000 loan on your home and it is worth $150,000, you have $50,000 of equity in your home. The lender then will allow you to use a portion of that $50,000. Some will let you use it all and others still will let you borrow up to 125% of the value of your home. They are banking on the fact the home’s value will steadily increase. The closer you get to borrowing 100% (or more) of the home’s value, generally the higher the interest rate on the loan.
Home equity loans vs. home equity lines of credit
There are home equity loans and home equity lines of credit. A home equity loan is for a fixed period of time, generally 10-15 years, at a fixed interest rate, with fixed monthly payments. This can also be referred to as a second mortgage on the home.
A home equity line of credit works like a revolving credit card in that you are given a credit line and can use up to your credit limit. If your credit line is $20,000 and you use $10,000 then pay it back in 5 years, you can then have $20,000 worth of credit still at your disposal. You pay interest only on the amount actually used. A home equity line of credit is usually accessed by writing checks against the account, where a home equity loan is issued to you in one lump sum either to you or designated creditors. Often on home equity lines of credit, you can pay the interest only for a set number of years, before you have to start repaying the principal.
Risk of using home equity loans
There is an inherent risk with using the equity in your home for expenses. If you do not make your payments on time, the lender has the right to foreclose on your home. So if you were to miss paying on $20,000, you could risk losing your entire $150,000 investment!
There are advantages to using your home’s equity for some expenses. If for example, you owe money on credit cards, the interest you pay is not tax deductible. The interest on a home equity loan or line of credit usually is. So it may make sense to use a home equity loan to consolidate your debt.
Be wise no matter what
It is important to consider how you plan to use the equity in your home. If it is for home improvements, then you are adding even more value to your home, which is good. If you are using it for vacations, cars or other items that quickly depreciate in value, then you could be risking your nest egg and run the risk of owing money on your home far longer that the average 30 year mortgage.