Home Equity: How to Use It
Let’s look at the different ways you can use your home’s equity.
Refinance: In essence, this is a way of paying off your current mortgage and getting cash out based on how much equity (the difference between the market value of your home and what you owe on it) you have in your home. This is a great way to lower or lock in your mortgage interest rate. This is the way to get large sums of money – $30,000 or more – because you have 15 to 30 years to pay it off.
On refinances, you may have to pay closing costs; discount points (used to increase the lender's yield or profit on the loan and equal to one percent of the loan amount); appraisal fees; application or loan processing fees; document prep and recording fees; origination or underwriting fees; lender or funding fees; loan broker fees; and miscellaneous other fees (i.e. overnight mail charges, etc.).
A home equity loan, a.k.a. a second mortgage, is good for homeowners who don’t need quite as much cash and whose mortgage interest rate is already competitive. The term is much less than a conventional 30-year mortgage – five to 15 years. These installment loans are paid out in one lump sum, so they’re good for repaying credit card debt or remodeling projects, even buying a new vehicle.
You must be sure you will be able to pay this loan back, because it’s easier to foreclose on a second mortgage than on a federally insured first mortgage. Find out about closing costs and points in advance, as well as balloon payments, hidden fees, or credit or property insurance tacked on.
A home equity line of credit works like a credit card – you agree to a pre-set limit and then borrow as you need to, or in the event of an emergency, usually for up to 10 years. These lines of credit are good for expenses like debt consolidation, major home improvements, college tuition and expenses, and unexpected expenses. The beauty of this is that you don’t make payments unless you use the money, but you have the security of knowing money’s there if you need it.
Some credit lines have variable interest rates, with no cap on how high they go. Make sure you read the fine print and find out exactly how much it could increase, then do the math. And if you’re an impulse buyer, this may not be a wise choice. A home equity line of credit shouldn’t be used for frivolous luxury items, unless it’s a one-time purchase and not a pattern of behavior.
7 best ways to use a home Equity loan
1. Home improvements
Home improvement is one of the most common reasons homeowners take out home equity loans or HELOCs. Besides making a home more comfortable for you, upgrades could raise the home’s value and draw more interest from prospective buyers when you sell it later on.
“Home equity is a great option to finance large projects like a kitchen renovation that will increase a home’s value over time,” Brunker says. “Many times, these investments will pay for themselves by increasing the home’s value.”
Another reason to consider a home equity loan or HELOC for home improvements is that you can deduct the interest paid on home equity loans of up to $750,000 if you use the loan funds to buy, build or substantially improve the home that secures the loan.
Why use home equity for this: You can use the value of your home to increase that value.
2. College costs
A home equity loan or HELOC may be a good way to fund a college education if your lender allows it. While student loans are still the most common way to pay for an education, the use of home equity “can still be advantageous when mortgage rates are considerably lower than student loan interest rates,” says Matt Hackett, operations manager at mortgage lender Equity Now. “It can also extend the term of the debt, reducing the payment.”
If you want to fund your child’s education with a home equity loan product, be sure to calculate the monthly payments during the amortization period and determine whether you can pay this debt off before retirement. If it doesn’t seem feasible, you may want to have your child take out a student loan, as they will have many more income-making years to repay the debt.
Why use home equity for this: Using home equity to pay for college expenses can be a good, low-interest option if you find better rates than with student loans.
Why you should skip it: Taking out home equity could be riskier. If you default on your loan, you could lose your home.
3. Debt consolidation
A HELOC or home equity loan can be used to consolidate high-interest debt at a lower interest rate. Homeowners sometimes use home equity to pay off other personal debts, such as car loans or credit cards.
“This is another very popular use of home equity, as one is often able to consolidate debt at a much lower rate over a longer-term and reduce their monthly expenses significantly,” Hackett says.
Why use home equity for this: If you have a significant amount of unsecured debt with high interest rates and you’re having trouble making the payments, it may make sense to consolidate that debt at a substantially lower interest rate, saving yourself money each month.
Why you should skip it: You’re turning an unsecured debt, such as a credit card that is not backed by any collateral, into a secured debt, or debt that is now backed by your home. If you default on your loan, you could lose your house. If you fall behind on credit card payments, you don’t lose anything (although your credit score will tank). You also risk running up the credit cards again after using home equity money to pay them off, substantially increasing the amount of debt you have.
4. Emergency expenses
Most financial experts agree that you should have an emergency fund to cover three to six months of living expenses, but that’s simply not the reality for many Americans.
If you find yourself in a costly situation — perhaps you’re out of work or have large medical bills — a home equity loan may be a smart way to stay afloat. However, this is only a viable option if you have a backup plan or know that your financial situation is temporary. Taking out a home equity loan or HELOC to cover emergency expenses can be a direct route to serious debt if you don’t have a plan in place to repay it.
Although you may feel better knowing that you could access your home equity in case of an emergency, it still makes smart financial sense to set up and start contributing to an emergency fund.
Why use home equity for this: If you have an emergency and no other means to come up with the necessary cash, tapping home equity may be the answer.
Why you should skip it: The lengthy application process associated with accessing home equity may not be ideal for a time-sensitive emergency.
5. Wedding expenses
For some couples, it might make sense to take out a home equity loan or HELOC to cover wedding expenses. According to The Knot’s Real Weddings study, the average cost of a wedding in 2020 was $19,000, down from the pre-pandemic figure of $28,000 in 2019. This doesn’t even include the average cost of the honeymoon.
To pay for this special life event, some couples turn to wedding loans, or personal loans used for weddings. However, the interest rates on these loans are typically higher than interest rates for home equity loans and HELOCs because they are unsecured — not tied to an asset.
Although tapping your home equity could save you money on interest, be careful not to take out more than you need. By having family members contribute or cutting costs on some wedding expenses, you might be able to reduce the cost of your dream wedding.
Why use home equity for this: Using home equity to pay for wedding expenses can be cheaper than taking out a wedding loan.
Why you should skip it: You can lessen how much you borrow by adjusting your wedding celebration, saving up for the big day, and asking family and friends for contributions instead of gifts.
6. Business expenses
Some business owners use their home equity to grow their businesses. If you have a business that requires more capital to grow, you might be able to save money on interest by taking equity out of your home instead of taking out a business loan.
Before you commit to taking this action, be sure to run the numbers on your business. As with using your home equity to purchase investments, a return on investment in a business isn’t guaranteed.
Why use home equity for this: You might be able to borrow money at a lower interest rate with a home equity loan than with a small-business loan.
Why you should skip it: If you haven’t tested out your business, your plan could fail and you’d still need to make payments on what you borrow — regardless of lack of earnings.
Important factors to consider
Even if you have substantial equity in your home and think it’s a good option for financing your home improvement project or consolidating debt, there are a few considerations to be aware of before tapping that equity.
The value of your home can decline
Keep in mind that there’s no guarantee that your home value will increase substantially over time. Your home may even lose value in times of economic downturn or suffer damage from fire or extreme weather.
If you take out a home equity loan or HELOC and the value of your home declines, you could end up owing more between the loan and your mortgage than what your home is worth. This situation is sometimes referred to as being underwater on your mortgage.
Say, for example, that you owe $300,000 on your mortgage but the home prices in your area tanked, and now the market value of your home is just $200,000. Your mortgage would be $100,000 more than the value of your home. If your mortgage is underwater, it’s much harder to get approved for debt refinancing or a new loan with more favorable conditions.
There’s a limit to how much you can borrow
There’s also a limit to the amount you can borrow on a HELOC or home equity loan. To determine how much money you’re eligible for, lenders will calculate your loan-to-value ratio, or LTV. Even if you have $300,000 in equity, the majority of lenders will not let you borrow that much money.
Lenders generally allow homeowners to borrow up to 80 percent to 85 percent of the value of their homes, minus existing mortgage balances. That number can be different from person to person, though, and depends heavily on your credit score, financial history and current income.
Know how not to use your home equity
Most lenders and financial advisers agree that the worst reason to tap home equity is for unnecessary personal expenses, such as an extravagant vacation or an over-the-top luxury vehicle.
While it may be tempting to spend your hard-earned money on something other than house payments, it is better to devise a savings plan to cover these fun but unnecessary expenses than to borrow from your house.
In addition, when it comes to your home equity, don’t borrow more than you need, don’t overspend and don’t put your house at risk of foreclosure for a frivolous purchase.
Next steps
Even if you use your home equity to add value to your home or to better your financial position in some other way, keep in mind that if you fail to repay a home equity loan or HELOC, you could lose your home to foreclosure.
Run the numbers and ensure that you can continue paying your regular mortgage on top of a new home equity loan and that you have a solid plan for improving your finances with home equity money.
-Pamela and Robert Jenkins