Good and Bad Reasons for Tapping Home Equity
Back in 2001 when banks were liberal with home equity loans and allowed up to 125 percent of a home's equity to be borrowed, Atlanta real estate agent Bruce Ailion got a home equity line of credit for $75,000 on his home.
The house he had bought for $280,000 was valued at $550,000, and Ailion says he thought it would be a good idea to have some money available for an emergency fund.
"I got it because they were easily available and just in case I needed it," says Ailion, a real estate agent at RE/MAX Town and Country in Atlanta.
He used a little of the home equity line of credit, or HELOC, to pay off part of a car loan, then got rid of the equity line a few years later when he refinanced his mortgage. In today's financial markets, those credit lines, and home equity loans, are typically limited by lenders to 80 percent of home equity.
With the Federal Reserve planning to raise short-term interest rates by the end of the year, now may be a good time to get a good rate on a home equity loan. Many home equity loans charge annualized interest of 6-8 percent, and loan rates could match increases in the prime lending rate.
How a home equity loan works
If you're thinking of getting a home equity loan, it's worth considering what you're using the money for and how you'll pay the loan back. The money can be used for whatever you like, from a new car to starting a business or consolidating credit card debt. Home improvements are the most common use.
The loan is for a specific amount for a fixed term at a fixed interest rate, with principal and interest paid monthly. Five years is the most common, though they can go for as long as 30 years, says Adam Block, home equity portfolio manager for Bank of America in Delaware.
Bank of America offers home equity loans of up to 85 percent of a home's equity to its value. A home valued at $100,000, for example, with a first mortgage of $50,000 can have a home equity loan of up to $35,000 as a second loan, Block says.
What money is used for is your call
Borrowers are checked for their credit worthiness and ability to pay, just as they would be for a first mortgage, he says. The bank will ask what the money is being used for, but the answer won't change their chance for approval, Block says.
"The usage doesn't really factor in," he says.
After home improvements, college tuition and debt consolidation are two other popular uses for home equity loans, Block says. Bank of America promotes responsibility with money, he says, and tries to help customers understand how they can afford their financial obligations.
"One of our overall goals is to make the customer's financial life better," he says.
"We always emphasize responsible use," Block says.
Home equity loan use options
While everyone's financial situation is different, here are some good and bad ideas for home equity loans:
Home remodeling or repairs
Which home improvements add value to a home and which don't is debatable, so the main consideration may be how much enjoyment you'll get out of a remodeling project or any repairs that are necessary
"When your home needs costly repairs, a new roof, new kitchen, new baths, or finishing a basement for added family or recreation, use of home equity for such improvements to the asset are common and a reasonable use of savings," Ailion says. "When the owner eventually sells the home the majority of this debt will be satisfied from the sales proceeds."
Losing a job, having unexpected medical costs, divorce and having to care for someone close are some of life's emergencies, and using a home equity loan for them can be wise, says John Crossman, president of Crossman & Company, a commercial real estate company in Orlando, Fla. that has an interest in consumers being healthy financially so that its business can prosper.
An emergency is the only good use for taking out equity in a home, Crossman says.
"It's better off keeping your debt lower, saving your money, paying off your credit card and stuff," he says.
Adding a bathroom or some other home improvement isn't going to help in the long run, he says.
"They're not really building equity in their homes," Crossman says. "They're giving it away."
Home equity loans can be used to consolidate debt and pay off credit cards. Interest rates on debt consolidation loans can be twice as high as home equity loans, which may be deductible on income taxes as part of a homeowner's mortgage interest.
Eliminating credit card debt with a home equity loan is OK if you have a master plan and a debt elimination deadline, Crossman says.
Start a business
Many businesses got their start with a $10,000 to $50,000 home equity advance, Ailion says, moving from working in their garage to becoming a full-time business.
"Having a plan that includes repayment of the home equity advance is critical," he says. "Many people with existing successful businesses can use home equity loans to expand their business."
Crossman disagrees, saying that a business startup, for example, would be better off if the owner got a second job and saved like crazy to get their business going.
This is another big use of home equity loans. Many homeowners have their home loan paid off as their children enter college, Ailion says, making a home equity loan a good source for paying for college.
As home prices skyrocketed in the mid 2000's, home equity loans were a way to use a home like an ATM and withdraw money for frivolous expenses such as a new car or boat. While lenders are unlikely to deny a home equity loan if you tell them you're using the money to buy a car, not having other funds to pay for it could lead to trouble if you can't afford the home equity loan payments.
"Using home equity for boats, cars, vacations and jewelry will in most cases result in less wealth rather than more," Ailion says. "All debt, including home equity, should be though of as used to acquire assets that will appreciate in value, have and maintain value in use, or to rehabilitate health, family or financial health."
Get Smart: Intelligent Ways to Use a Home Equity Loan
In the 1965 television series Get Smart, Agent 86, Maxwell Smart, did everything to not live up to his name. Luckily, he had the brilliant and beautiful Agent 99 to help him overcome all obstacles and ultimately finish as a winner. As Max would say, "If you don't mind, 99," we'd like to step in and offer some smart advice on home equity loans that you can believe.
Know Your Budget
Home equity loans are highly structured. You apply for a specific amount, you receive the money all at once, and then you repay in fixed monthly increments. This structure is ideal for funding a planned expense like a home remodel or new car purchase. If you can't budget the expense accurately, a home equity line of credit (HELOC) might be more appropriate.
Leverage the Tax Advantages
Borrowing from your home's equity may give you access to certain tax breaks that you don't receive from being indebted to credit cards or auto loans. Since home equity loans are a type of mortgage, the interest you pay on them is tax deductible for most people who itemize deductions, within certain limits.
Everyone's situation is different, however. That's why it's best to talk with your financial advisor to understand how the additional mortgage interest will affect your tax liability.
Set a Little Aside
Home equity loans have many potential uses. In addition to acting as a home improvement loan, they can be a lifesaver when tackling unforeseen expenses. If possible, avoid tapping all your equity to ensure that there's additional funding if an emergency arises.
Be a Savvy Shopper
Before you select a lender, research current home equity loan rates and shop around to get the best deal possible. If you have good credit, you should be able to obtain an equity loan with no closing costs. Be on the look-out for application fees, appraisal fees and broker fees in particular; you don't want those added to your loan balance. A recording fee might be unavoidable, but this money goes to the local government's recording office, not the lender.
Their low rates and allowed tax deductions make home equity loans a very attractive way to borrow money. However, there's a risk in using them too much. Home equity loans and lines of credit may be affordable, but other types of consumer lending don't put your home at risk if you fail to keep up with the payments. Their ready availability can also temp you into using them for non-essential expenditures that it might be better to fund through other means that don't put your home on the line.
Their long repayment periods - up to 30 years – can also disguise just how much debt you're taking on because your payments will remain low. You'll just have to keep making them for a long time. And continually tapping your home equity delays the day when you own your home free and clear, which is an added financial burden in itself.
Be Smart to the Max
Agent 86 might say that it's the old "use-your-home-equity-intelligently-to-enhance-your-life" trick. He should know. After all, his last name is Smart.