As home prices climb, an ever increasing number of home owners are taking advantage of their extra equity by getting a home equity loan or a line of credit. But accessing your extra home equity should be done carefully, and only in a narrow set of circumstances.
Remember about ten years ago? That was the end of the last market peak, when homeowners were yanking money from their homes as if they were endless piggy banks. They used the money to purchase nice furniture, buy new cars, and even roll it back into the home in the form of luxury, but unnecessary improvements.
When the bubble popped, many of those borrowers lost their homes as property values tanked. They couldn’t sell the home for what they owed, including both the main mortgage and equity loans.
So, what are the lessons we can learn from those unfortunate times? Just this: If you’re considering taking out a home equity loan or line of credit there are smarter ways to think about those funds. Here are four things to think about before tapping into that extra equity.
1.Know what type of equity loan to get
There are two types of loan you could get
- A home equity loan. This allows you to get a lump of cash all at once—a loan—and then pay it back over a fixed term at a fixed interest rate, much like a mortgage or car loan.
- A HELOC (home equity line of credit). This is a type of loan that works more like a credit card. You get an amount credit—a credit line—that you can use whenever you need it, for a limited term, such as five or 10 years, followed by a repayment period of up to 20 years. It has an adjustable rate that changes with the market.
A home equity loan makes sense if you need a large amount all at once for a specific project, such as a roof replacement.
A HELOC might make more sense if you need to borrow smaller amounts over a longer period. HELOCs carry a variable interest rate, so be careful of getting sucked in by the low starting rate. Since home mortgage rates are already nearly as low as they can go, the only direction for the rate on a HELOC to go is up, adding to your payments over time. A HELOC could end up costing you more in the long run than if you’d gotten a straight home equity loan in the first place, even if at a higher rate.
Another drawback to the HELOC is that lenders can stop or reduce the amount of your line of credit without warning if they learn of a change in your financial circumstances or a drop in your home’s value. That means you can’t always count on a HELOC to be there when you want to use it. A classic example of this is when you want to buy another home and use your HELOC funds as part of your down payment. The instant your old home goes up for sale, the HELOC may come due in full.
You also need to know how much you can get with a HELOC or equity loan. It may not be as much as you think it will be. Banks figure out what amount to give you based on adding the amount you’re seeking to the balance of your primary mortgage. If the total will retain 10% to 30% equity in the property, depending on the banks policy and your credit score, you get that amount.
For example, suppose the bank is strict and requires a cushion of 30% equity. You want a HELOC of $30,000 and your primary mortgage debt is $285,000. The total you would owe is $315,000. If the market value of the property is $400,000, then you have a pretty good chance of getting that loan, provided your credit is sound. But if the property is only worth $370,000, you may have a problem getting $30,000. You may be able, however, to get $10,000.
For that reason, it’s important to work with your lender to understand their equity cushion requirements and work with your real estate agent to understand the fair market value of your home. Then your lender can help you calculate the amount you would be eligible to borrow.
Some credit unions will let their members borrow 100% of the equity in their home, so that’s an option to consider checking into.
2. Be Crystal Clear About What Your Payments Will Be
Of course the monthly payment you’ll have to make to repay your loan will depend on the interest rate you get, the amount you borrow, and the way you’ll pay it back. But here are a few more thoughts about that.
Since home equity loans have a fixed interest rate and term, you can use an online payment calculator to estimate your repayment plan. It’s straight forward, and easy to estimate and plan.
However, HELOCs are more difficult to predict, because the interest rate changes over time. They also can be repaid in different ways, depending on what you agree to with your lender. Most HELOCs require you to make lower, interest-only minimum payments for the first 10 years while the line of credit is open to use. But in the 11th year, the line of credit is closed, and the principal must be repaid over the next 10 to 20 years.
Of course, it’s better to pay back the loan quickly to minimize the amount you pay in interest, and to also get rid of the loan. If the market were to fall again, even slightly, you could find yourself upside down when you want to sell.
3. Avoid Dead End Uses Of Your Extra EquityDuring the housing bubble prior to 2007, consumers used home equity to pay for everything from boats and gambling to cars and kitchen renovations. When they lost jobs due to the economic downturn, they found themselves upside down in their homes, unable to sell them for what they owed. That led to foreclosures. The problems those home owners faced as the market crashed have taught us to scrutinize our reasons for using home equity.
Lenders used to think that using a HELOC to finance a car or a kitchen remodel was acceptable. But not so much these days. Now car loans are so cheap that lenders believe a home equity line doesn’t make sense for a car purchase.
The same goes for home remodeling. Now lenders think it’s a better idea to save for those things. (When did we decide it was OK to borrow and not save for things we want, anyway?) Even though home improvements can boost the value of your home, it’s seldom as huge as they amount you see on HGTV. And anyway, if you use your home equity to remodel, either you should be comfortable with the higher payment, as if you’d bought a more expensive home, or you’ll want to resell quickly to pay off the home equity line.
Using a home equity loan is an option if you plan to flip a home quickly for profit. But you’d only take that option if you absolutely understand what you’re doing. Remember, a lender could call that loan due immediately when the house goes up for sale. That could be a problem if the home doesn’t sell quickly, or there are problems with the escrow.
4. When Is It Appropriate To Use An Equity Loan Or Line Of Credit?
If you need cash to make essential repairs for your family’s safety or your home’s structural integrity, then home equity borrowing makes sense. These are things like fixing a worn-out roof that’s leaking and causing water damage, or faulty wiring that can start a fire, or a foundation that’s tilting, or even adding gutters to prevent further water damage.
What about college loans?
With rising college tuition and college loan borrowing costs, it might make some sense to use equity to pay your child’s tuition. The interest rates on a HELOC or equity loan can be lower than those on student loans. But, consider that a full refinance on your first mortgage might be less expensive, since first mortgage rates are cheaper than home equity rates. You’ll want to compare the interest rates and closing costs to see which option is cheaper.
However, if you’re considering putting part of a semester’s tuition on a credit card and carrying a balance, using a HELOC to manage short-term cash flow might be a much better option. You can still pay back the HELOC faster than your payment plan.
Use equity to cut your high credit card interest payments
Possibly the smartest way to use home equity is to pay off all of your high-interest credit cards. You’ll be repaying those debts using the much lower interest rates from your home equity loan or line of credit. In that case, you’ll get out of debt faster by using the money you were paying to those high interest cards, and sending it to pay your home equity line or loan instead. But you must be strict in your use of credit from that time forward, and not use your newly open credit cards as a license to start running up the balances again. The point of using your home equity in this way is to get out of debt!
You can use a debt consolidation calculator to help see how much you can save by paying off high rate cards.
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About Bill Leeper
Bill is a founding partner of Your Colorado Home Group based in Denver and has a long record of successfully guiding local, national, and multi-national clients in buying, selling, and investing in real estate.