A lot of homeowners are building some nice equity these days, as high demand and a shortage of starter homes continue to drive up prices in many parts of the country. If you’re one of them, are you thinking about tapping your equity?
There’s a time and a place for leveraging your home equity. But please, think long and hard before doing it. That dream trip to Belize is definitely off the table!
Unless you’re using your home equity as the down payment on a different home, you’re reversing the equity-building process. You’re decreasing your wealth and increasing your debt. And what if home prices fall? You’ll be more vulnerable to ending up underwater on your mortgage — owing more than your home is worth.
It’s also important to take in that when you use your equity, your home is the collateral. That can get you a better interest rate on a home equity loan, but it also means that the lender can foreclose on you if you fall behind on your payments. That’s right. You could lose your home, same as if you default on your mortgage.
So, like we said, think long and hard. Here’s food for thought on six ways homeowners spend their equity — some smart, some not. If you’re not sure what to do, a local homeownership advisor can help you sort out your options.
Worst move: fun in the sun
We’re talking about that trip to Belize. Or … What tempts you? A new boat? A fancier car? A fantabulous wedding? We’re pretty sure you know this, but for the record: a splurge isn’t worth risking your home for.
Smartest move: home improvements
Need a new roof? Thinking about a second bathroom? Putting your equity back into your home can be a good call if you’re making critical repairs or upgrades that add market value (like that roof or bathroom). Many financial advisors say it’s the only reason to use your home equity.
Yet there are lots of ways to pay for renovations. Before you tap your equity, explore options that don’t put your home on the line. You might even find a loan with a lower interest rate. The best choice depends on how much money you need and how much equity you have.
Emergencies: necessary evil
Your home equity isn’t a substitute for an emergency fund. One of the reasons to save an emergency fund is to leave your equity intact if your heating system fails or your appendix blows. But sometimes, what can you do? If you don’t have the cash on hand, your home equity could be the best way you have to deal with a big, unexpected bill.
Tip: The threat of huge medical bills is a fact of life for growing numbers of Americans. If you have a high-deductible insurance plan, you’re probably eligible to start a health savings account (HSA). Up to a certain amount each year, your contributions are tax-free, and you can gradually stockpile money for a wide range of health-related expenses, not just emergencies.
Credit card debt: don’t “reload”
Some homeowners tap their equity for debt consolidation, including paying off high-interest credit cards. Because home equity loans have much lower interest rates — maybe 5 percent as opposed to 17 percent — this can be a money-saving move. However, there’s more to consider.
First, are you being real with yourself about what you’re doing? When you consolidate debt with a home equity loan, you’re not paying off the debt, you’re just moving it around. If you don’t change the habits or circumstances that got you into debt, and you run up those cards again, you’ll be in even worse shape than before. This syndrome is so common that lenders have a name for it: “reloading.”
Second, credit card debt is unsecured debt. That means it’s not guaranteed by any physical collateral. If you fail to pay the debt, it’s hard for the credit card company to come after your house (although they might try; state laws vary). If you pay off the debt with a home equity loan, the debt is now secured by your house. So if you default, the lender has a clear right to foreclose on you.
BTW, if your debt is starting feel out of hand, a local homeownership advisor can help you with that too.
Student loan debt: think twice
Did you manage to buy a home despite student loan debt? Congratulations! If you’ve now built up some equity, you might be considering whether to get those loans out of your life by replacing them with a single home equity loan at a lower interest rate.
It sounds good, but the problem is the same as with credit card debt. You’re just moving the debt around, and you’re converting unsecured debt into debt secured by your home. You risk foreclosure if at some point you can’t pay. Defaulting on your student loans will hurt your credit, but you won’t lose your house.
Also consider that once you convert a federal loan into a private loan (home equity or other), you’re no longer eligible for federally sponsored programs like deferment, income-driven repayment, and public-service loan forgiveness.
Other investments: risky
Some homeowners use their equity to invest in the stock market or other real estate, betting that the returns will be higher than the cost of taking out the home equity loan or line of credit.
First of all, we chose the word betting for a reason. The return on the new investment might not make up for the cost of the loan. Plus, while stock and real estate investments can be an important part of an overall money strategy, when you use your home equity to make them, you’re compounding the usual risks by putting your home on the line.
Here’s another idea: If you want a guaranteed return on investment, put more money into your home in the form of consistent payments on principal. Besides building home equity faster and paying off your mortgage earlier, you’ll save (and in a sense, “earn”) tens of thousands of dollars in interest over the life of your mortgage.