It costs a lot to borrow money right now. Average credit card rates are above 20%, and personal loans for borrowers with excellent credit have interest rates above 10%, according to the most recent report from CNET’s sister site, Bankrate. But there are more affordable options: a home equity loan or a home equity line of credit (HELOC).
When you borrow money by unlocking your home equity, you’re telling a lender that they can take your house if you don’t pay back the money. Since the lender has a claim to a valuable asset, they’re willing to lend you funds at a lower interest rate than many other forms of financing.
It can be worth taking equity out of your house to tackle important life expenses that you don’t have the cash to cover. But should you risk the roof over your head? Read on to learn more about the reasons why leveraging your home equity can be a smart way to go.
How does home equity work?
Home equity is the difference between what you owe on your mortgage and the current value of your home. As you make monthly mortgage payments over the years, the equity in your home increases because you’ve paid off a higher percentage of your loan.
Home equity loans require that you put your house up as collateral to secure what will now be your second mortgage, i.e., a new loan on top of your existing mortgage. That’s why personal finance experts say you should carefully consider your financial situation and the types of expenses that are worth the risk if you can’t afford the monthly payments.
5 reasons to use a home equity loan
If you’re a homeowner, tapping into your home equity can be a lifesaver if you need money, especially if you’re considering a personal loan or using credit. A home equity loan will give you access to a lump sum of cash at a fixed interest rate, while a HELOC gives you access to a revolving line of credit at a variable interest rate. Either one can be used to finance an ongoing project over a long period of time or to consolidate debt.
Here are five reasons to use home equity.
1. Home renovations or improvements
The biggest benefit of completing home renovations with a home equity loan is that your interest is tax deductible, which gives you valuable savings. Plus, you get to enjoy those home improvements while increasing your home’s value. That means you might be able to sell it for more down the line.
2. Debt consolidation
If you have a mountain of high-interest credit card debt, a home equity loan or home equity line of credit can help you pay it off at a much lower rate. For example, if you’re trying to pay off $20,000 across three cards with interest rates above 20%, a home equity loan might allow you to reduce that interest rate to less than 8%. By consolidating debt, you’ll be saving thousands of dollars while getting the convenience of just one monthly payment instead of three.
3. Higher education costs
College tuition is one of the largest expenses facing families today, and home equity loans can help provide upfront funds over an extended period of time. It’s important to consider the type of loan, though. Direct federal student loans for undergraduates have interest rates of 5.5% right now, much lower than the average for home equity rates. If you’re considering taking out private student loans, however, home equity borrowing can be much cheaper.
4. Emergency expenses
If an event that’s out of your control disrupts your finances, such as unplanned medical bills, a home equity loan is one option to consider. But it’s worth asking the business, hospital or creditor if you can go on a payment plan first. If a payment plan is an option, then you don’t need to put your house at risk by taking out a second mortgage.
5. Business-related expenses
Using a home equity loan to reinvest in your business can pay off if handled cautiously. If you evaluate the health of your business, have a fully fleshed-out business plan, and know what you’ll do if you run out of funds, you could consider it an option.
Factors to consider before taking out a home equity loan
Your home’s value
While home prices soared over the past two years, the housing market is slowing in response to rising mortgage rates and inflation. You can end up “underwater” on your mortgage when what you owe on your home exceeds the value of the property itself.
Borrowing limits
Your bank or lender will typically allow you to take out 75% to 90% of your home’s loan-to-value, or LTV, ratio, which is your outstanding mortgage balance divided by your home’s current value. Make sure you can borrow enough to cover your needs.
Spending habits
If you want extra cash to spend on nonessential items, such as a vacation or a new car, think twice before signing off on a home equity loan. Funding home improvements that will enhance the value of your home or investing in something that will substantially improve your financial situation is different from discretionary or superfluous expenses.
The bottom line
You can use a home equity loan to access cash for a variety of reasons, from funding home improvement projects to consolidating debt. But it’s important to remember that your home is the asset securing your loan. Carefully consider the responsibility of paying back a large loan over a long period of time and the risk of foreclosure if you miss payments.
FAQs
Applying for a home equity loan or a HELOC could have a small negative impact on your credit score. However, that’s not a reason to avoid one. In the long run, as long as you make your payments on time, a home equity loan will help you continue to build your credit.
Yes, which is why you need to think very carefully before borrowing. Because your home serves as collateral, the lender can foreclose on the property if you fail to make payments.
It depends on how you’re using the funds. If you’re using the money to make home improvements, the interest is tax deductible. However, if you’re using a home equity loan for any other purpose, like consolidating credit card debt, there are no tax benefits.
It depends on the lender. Generally speaking, closing costs are more common on home equity loans, but they vary between 1% and 5% of the loan amount. For HELOCs, many of the best home equity lenders charge considerably lower fees and promise to waive closing costs as long as the line of credit is open for a minimum amount of time. It’s important to note that it’s common to see annual fees – $50 to $100 – for HELOCs.
