Home Equity Loans: Should You Access Your Equity?
Weighing the risk versus the reward when cashing in on your greatest asset.
For most people, a house is not only where you call home; it’s also your greatest financial asset. Unlike a car, homes typically gain cash value over time. A home equity loan allows you to borrow against that value for strategic financial gain. But is an equity loan the right choice?
What is home equity?
Equity is the fair market value of a property minus any remaining balance owed on the mortgage. If your home is worth $250,000 and you have $100,000 left to pay, you have $150,000 in equity.
Equity generally increases over time for two reasons:
- In general, unlike cars, homes increase in value over time. Although property values fluctuate, the trend over the long term is usually positive.
- As you pay off the mortgage, there is less liability to offset the property value.
Home equity loan definition
A home equity loan is a financing option where you borrow against the value built up in your home. In most cases, you can only borrow up to roughly 85% of the home’s value. You take out a new mortgage that pays off the old and then gives you a payout of the difference.
Using the example above:
- If the home is worth $250,000 then 85% of that value would be $212,500.
- Minus the remaining $100,000 balance on the mortgage, you could finance up to 62,500 with a home equity loan.
Bear in mind that you typically must pay closing costs if you take out a home equity loan. Closing costs generally range from about 2 to 5 percent of the loan amount. The interest rate on the equity loan depends on your credit score. This means you should have a good credit score to apply for a home equity loan effectively.
Home equity loans are often commonly referred to as “second mortgages” because you effectively have 2 loans taken out on one home.
Loan vs. line of credit
It’s important to note that there is another way to access equity in your home. It’s known as a Home Equity Line of Credit (HELOC). With a HELOC you borrow funds against the equity in your home on a need basis. Instead of taking out a full loan for an amount you may not need, you can simply open the line of credit and pull out funds as needed.
HELOC offers a few advantages, such as no closing costs. But the payments on a HELOC can be trickier to manage. A HELOC is generally an adjustable-rate loan that has interest-only payments for a period of time. In most cases, principal repayment doesn’t start until 10 years after you open the HELOC. After 10 years, the payments balloon because you must pay back the principal, as well as the interest.
By contrast, home equity loans typically have fixed interest and fixed monthly payments. This can make it easier to manage the debt. Consider all your options carefully before you decide which financing option is right for you.
5 common uses for home equity
Making the choice to access your home’s equity is not a decision you can take lightly. The equity is yours to use, but remember that adding additional financing to your home increases your risk. If you default on a home equity loan or HELOC, you can be at risk of foreclosure.
This means you should only use this type of financing option if you have a clear, strategically viable reason to do so. You should also determine if taking out the loan or HELOC will increase your risk, and by how much.
Use #1: Renovation and remodeling projects
Home renovations and remodeling are one of the most common uses for this type of financing. You use the equity in your home to fund home improvement. This increases the value of the property, so it’s a little like spending equity to get more equity.
Always consult with an expert before making the decision to access your equity. If you want to use this option, we recommend a quick, confidential consultation with a housing counselor to weigh your options. Call 1-800-435-2261 to request a HUD-approved free consultation.
Use #2: Invest the money you receive
It may seem strange, but you can use home equity loans to strategically invest your money. If the rate of return is higher than the interest rate on the loan, then it can be a smart choice. This only works when mortgage rates are low and the investment market is strong.
It’s also worth noting that the “borrow to invest” concept doesn’t require you to rely on equity. You can take out an unsecured personal loan to do the same thing.
Use #3: Cover education costs
Student loan debt can be an immense burden. It’s one of the only types of debt you can’t easily discharge through bankruptcy. The government can garnish your wages and tax refund or levy your bank account. And the monthly payments can consume your budget if you have limited income.
That’s why some people use equity to cover education costs. You can take out the equity loan ahead of school to pay tuition and other costs directly. You can also use the equity to pay off your student loans. Just be careful that this doesn’t put mortgage stability at risk.
Use #4: Supplement an emergency fund
If you have a major expense that comes up that you can’t cover with savings, you can use a home equity loan or HELOC to provide the cash you need. This is better alternative than taking out a payday loan that can have finance charges over 300%. However, it’s a better idea to have savings serve as your emergency fund. Setting aside cash means you don’t need extra financing to cover a serious expense.
Use #5: Pay off credit card debt
The last reason people commonly take out home equity loans is for credit card debt repayment. If you have a large volume of credit card debt to pay off, a home equity loan may seem like a viable solution. However, it most cases the reward is not worth the risk in this situation.
Credit cards have notably high interest rates – most cards have rates in the high teens or twenties. By contrast, a home equity loan or HELOC would typically have a much lower rate. The problem is that you take out a secure loan to pay off unsecured debt. This significantly increases your risk.
Credit cards are generally unsecured debts. This means there is no collateral attached your debt. As much as a collector might threaten you, they can’t actually take your property without a civil court judgment. In other words, they must sue you.
But if you use an equity loan to pay off your credit cards, now the debt is secure. If you can’t pay back the loan, you could be at risk of foreclosure. By taking out the loan, you increased your risk in a way that’s usually not worth the return.
Home equity loans versus other financing tools
The following pages can help you better understand how equity loans relate to other financing options. This can help you make more informed decisions when choosing the right lending tools for your needs.
Home equity loans vs. reverse mortgages
A reverse mortgage is a specialized financing option available to senior homeowners age 62 and up. It allows seniors to access home equity without adding risk of loan default seen with standard home equity loans. Both options allow you to access equity, but there is less risk with a reverse mortgage.
Home equity loans vs. personal loans for consolidation
A home equity loan is basically a secured version of an unsecured personal consolidation loan. However, making the debt secured means increased financial risk for the borrower. We compare these two lending products to help you understand why you should use one and not the other when you want to eliminate credit card debt.
Home equity loan vs. HELOC
Compare home equity loans versus home equity lines of credit (HELOC) to understand how these two financing options differ. Do you need a lump sum of cash on the spot or an available credit line you can draw against? In either case, learn how to protect your home while accessing equity.