As a homeowner, every time you make an amortized mortgage payment, and every time your home increases in value, you build wealth in the form of home equity. And, used judiciously, your home equity can work for you.
|Market value of your home:||$250,000|
|Balance of your mortgage:||$175,000|
|Your home equity ($250,000 – $175,000):||$75,000|
Tapping into your home equity is very different from taking out a consumer loan or using your credit card. Because you are using your house as collateral, you will likely be able to obtain a lower interest rate on a home equity loan or home equity line of credit than on an unsecured loan. You may also be able to deduct the loan’s interest on your tax return, reducing the cost of borrowing even further. (Speak to a financial advisor for advice on your particular situation.)
The caveat, however, is that home equity loans carry lower rates because they are secured with your property. This means that if you can’t meet your payments, you could lose your home. That’s why you should never overextend yourself. Only borrow an amount you’re sure you can comfortably repay.
3 ways to use home equity
There are three common ways to tap into your home equity, including:
- A home equity loan (HEL, also known as a “second loan”)
- A home equity line of credit (HELOC)
- Cash-out refinancing.
For more information on these options, read How to turn your home equity into cash.
Be a smart borrower
Using your home equity wisely means putting it toward something that will go up in value, or that will save you money over the long term. Many people take out a home equity loan for home renovations, such as a new kitchen. This can be a wise choice, since remodeling typically adds value to your house, and you may recoup some of the money when you sell.
A home equity loan may also be an excellent way of consolidating other high-interest loans. If you owe $20,000 on several credit cards -- which may carry rates of 18 percent or more -- transferring the balances to a home equity loan may save you thousands in interest charges. It’s worth stressing, however, that this only works if you commit to changing your spending habits.
Finally, a home equity line of credit can be a substitute for an emergency fund. If you’ve built up a large equity stake but have little savings available for an emergency, obtaining a HELOC in an amount that would cover two or three months of living expenses may make sense for you. You won't need to touch the money -- and therefore won’t pay any interest -- unless you suffer an illness, job loss or other crisis. Be aware, however, that lenders can freeze or lower your line of credit at any time.
It is usually not a good idea to dip into your home equity to indulge in short-term pleasures such as a vacation or luxury items such as a boat or second car. These expenses erode your wealth rather than building it.
Understand the risk
Leveraging the equity in your home can be a smart financial decision, or it can be disastrous. Before you consider a home equity loan, make sure you understand the potential risk involved:
- If you borrow a high percentage of your total equity, a down-swing in the real estate market could leave you owing more than your property is worth.
- If you default on the loan, you may be forced to sell your home. If the lender forecloses, your credit rating will be severely damaged and you may even be forced to declare bankruptcy.
Using your home equity responsibly will ensure you avoid the potential risks and reap only the rewards.
Return to Financial Literacy Guide.