4 smart moves for using home equity
Home prices continue to rebound from the recession, home equity loans and lines of credit are becoming potential sources of extra cash for an increasing number of homeowners.
More than $120 billion in new home equity credit lines of credit were opened in the 12 months ending June 30, according to the most recent data available from Experian, one of the nation's major credit reporting agencies.
That's a 27% increase over the previous year.
While home equity lending is still well below what we saw in the housing bubble, the credit bureau reports that new borrowing has practically exploded in some states — up 169% over the past year in Wyoming, 85% in Oklahoma, 79% in Arizona, 53% in Florida and 52% in Ohio.
This return to using equity should be done with extreme caution — and for a very narrow set of reasons.
Remember, borrowing against your home puts it at risk of foreclosure if you can't pay the bill. For most purchases, that risk isn't worth it.
"HELOCs can be an excellent money management tool when used properly," says California-based mortgage consultant Greg Cook. "Unfortunately, many consumers used them as ATMs during the housing bubble and as a result found themselves in worse financial shape than when they started."
If you're thinking about borrowing from your home's equity, take a conservative approach.
Our 4 smart moves will help get you started.
Smart move 1. Choose your loan wisely.
Home equity rates are very attractive right now.
The average cost of a $30,000 HELOC began 2014 at 5.20% and fell to 4.72% in our last survey of the year. That's the cheapest those loans have been since August 2004 — or nearly 10 years ago.
The average interest rate for home equity loans has fallen from a high of 6.23% in September to 6.03% at the end of 2014, and the lowest it's been since January 2013.
Both offer lower interest rates than most other forms of consumer credit, and the interest is typically tax-deductible.
But they aren't as easy to get as they once were.
Credit score and loan-to-value requirements are considerably more stringent than they were prior to the housing crash, Cook says.
Lenders often require borrowers to have a combined loan-to-value of no more than 90%, he says.
That means if your home appraises for $300,000, and your mortgage principal balance is $200,000, you might be able to borrow as much as $70,000 with a home equity loan or line of credit. You’d retain 10% equity, or $30,000.
Some lenders require 80% loan-to-value.
To get the best interest rates with most lenders, you’ll need a credit score of at least 740, says Gregory B. Meyer, community relations manager for Meriwest Credit Union in San Jose, Calif.
If you can tap your home equity, it's a much cheaper way to borrow than, say, using a credit card. But you won't lose your house if you default on a credit card.
There are two ways you can borrow from your home's equity:
- A home equity loan lets you borrow a lump sum and pay it back over a fixed term at a fixed interest rate (like a mortgage or car loan).
- A HELOC works more like a credit card. It makes a certain amount of credit available on an as-needed basis for a limited term, such as five or 10 years, followed by a repayment period of up to 20 years. Its interest rate changes with the market.
A home equity loan makes sense if you need a large amount all at once for a specific project.
A HELOC might make more sense if you need to borrow smaller amounts over a longer period.
You might be tempted to choose a HELOC because of its lower interest rate.
But since today’s interest rates have almost nowhere to go but up, a HELOC's variable interest rate could end up costing you much more over the loan term than a home equity loan’s fixed rate, even though the fixed rate is higher initially.
HELOCs have another significant drawback.
"Most HELOCs will have a feature where the lender can freeze the line of credit at any time — for instance, if the lender believes the value of the home has dropped significantly since the line of credit was opened," says loan officer Hillary Legrain of First Savings in Bethesda, Maryland. "So that line of credit you open may not always be available to you in the future."
For either option, you'll need to provide full documentation of income and assets and an appraisal, she says.
Smart move 2. Calculate your own repayment schedule.
If you choose a HELOC, take steps to reduce your risk.
HELOCs typically offer some initial flexibility in how you repay them.
During the draw period, usually the first 10 years, you can make interest-only payments.
However, if you only pay the minimum now, you’ll experience payment shock later when the full monthly payments, including principal, kick in.
It’s not safe to assume you’ll be able to afford the higher payments in a few years, especially because the interest rate could increase in the meantime.
We’re seeing the effects of consumers’ faulty assumptions right now.
About 40% of all outstanding U.S. home equity loans are at or near their 10-year mark, and borrowers are increasingly missing their payments, which have already doubled or tripled and will jump even higher when interest rates increase, Reuters reports.
You also may not want to choose the longest loan term possible.
A better option is to pay the loan back quickly to minimize the amount you pay in interest, get rid of the monthly payment and eliminate the risk of having your home as collateral for a secondary purchase.
Our line of credit calculator can help you do the math and determine how long it might take to pay off your credit line.
Smart move 3. Limit your use of equity.
Borrowers traditionally have used their home's equity to pay for everything from cars to planned renovations.
Today, auto loans are both less risky and cheaper. And the prudent approach to home renovations is to use cash if you can. It doesn’t make sense to pay interest on a project with a negative return.
There are few appropriate uses of home equity loans, because it doesn’t make sense to put your shelter at risk for nonessential purchases, says Cecily Welch, a certified financial planner and certified public accountant with Welch Financial Advisors in Atlanta.
Welch says one appropriate use is to make essential repairs of things that wouldn't pass a home inspection in order to sell your home.
With rising college tuition and borrowing costs, you might be tempted to use home equity to pay for your child's tuition. The interest rates can be lower than those on student loans, especially private student loans.
But a cash-out refinancing on your first mortgage could be even less expensive, since first mortgage rates are below home equity loan rates. You’ll need to compare the interest rates and closing costs to see which option is cheaper.
Financial experts say you should not sacrifice your own future to help your child pay for college, though.
While we don't recommend leveraging all of your equity to pay for school, using a HELOC for short-term cash flow is a much better option than putting part of a semester's tuition on a credit card.
Smart move 4. Use equity to cut your interest payments.
You could use the loan proceeds to pay off all of your high-interest credit card debt and diminish the damage from your past mistakes by repaying your debts at the home equity loan’s lower interest rate.
"Paying off consumer debt with tax-deductible funds can improve a homeowner's overall financial situation if they use the savings to reduce the balance of the equity line," Cook says.
In other words, if you just make the minimum interest-only payments and stretch out your debt for another 20 to 30 years, you won’t come out ahead.
"If the debt consolidation will save $500 a month, apply at least 50% of the savings to pay down the principal balance of the home equity line," Cook says.
Keep applying the interest savings to the new loan’s principal balance until you've repaid the total amount in full.
Borrowers also have to change their spending habits, or they will get back into the same or a worse situation with their bills, Meyer says.