The Best (and Worst) Ways to Leverage Equity in Your Home
One of the many perks of homeownership is seeing a boost in your home’s value when the housing market is performing in your favor. Not only can you increase your profit once you sell your home, but you have an appreciating asset that allows you to leverage equity as needed.
But just because you have equity doesn’t mean you know what to do with it. We’ll cover the smartest things you can do with your home equity that won’t impede your long-term financial goals.
What is home equity?
Home equity is the difference between how much your home is worth and how much you owe on your mortgage. As you make mortgage payments, your mortgage principal balance reduces and you build home equity. If your mortgage balance is worth more than your home’s value, you have negative equity and are underwater on your loan. But if your mortgage balance is lower than your home’s value, you have positive equity that could be converted into cash.
Even better, when your home’s value rises because of market factors, you gain equity without having to do anything at all. Between January of 2021 and June of 2022, U.S. homeowners saw a record gain in home equity due to rising home prices, with an average of $60,000 gained.
Here’s three common ways to leverage equity in your home:
→ A home equity loan, which is disbursed to you in a lump sum. The loan is repaid in monthly installments over a set term of five to 30 years (similar to your mortgage). Home equity loans typically have a fixed interest rate.
→ A home equity line of credit (HELOC), which is a revolving line of credit that works like a credit card. You only pay back what you spend, plus interest, and your credit line can be reused as long as you have access to it. HELOCs usually come with variable interest rates, but fixed-rate HELOCs may be an option.
→ A cash-out refinance, which is a type of refinance that allows you to replace your existing mortgage with a home loan for more than what you owe. You pocket the cash difference between the two loans.
6 best ways to leverage equity in your home
Once you tap your home equity, you can use the money however you want. However, some ways to leverage your equity are more risky than others. Here are some options:
It can be a smart move to leverage real estate equity to cover your next home improvement project, though not all improvements offer the return on investment you may be looking for.
Replacing a garage door can give you a 93% ROI, according to Remodeling Magazine’s 2022 Cost vs. Value Report. Meanwhile, you may recoup 59% of the cost of a typical mid-range bathroom remodel, but gain only about 52% of the cost of a bathroom addition.
Of course, there are times when home improvements are crucial, whether or not you intend to sell or need to earn back your investment. If, for example, you desperately need a new roof to avoid leaks and other damage to your home, that would be a smart way to use home equity, regardless of how it may impact your home’s value.
Another benefit to leveraging your equity to pay for home improvements is that you may be able to deduct mortgage interest paid on a home equity loan, HELOC or cash-out refinance at tax time. You’ll lose that perk if you tap equity for other reasons.
Real estate investing
You could also leverage equity to jump-start a foray into real estate investing. Let’s say you’re interested in getting an investment property loan to buy a rental property. One of the key requirements is a minimum 15% to 20% down payment, depending on your credit score.
For example, you’d need to put down $30,000 to $40,000 to buy an $200,000 investment property, which could come from a home equity loan or HELOC against your main home. Ideally, that property would provide enough rental income to cover your mortgage payments — including principal, interest, property taxes and homeowners insurance — plus maintenance, repairs and the home equity loan or HELOC payments.
Once you’ve built up significant equity in your first investment property, you can rinse and repeat the process by leveraging equity in that property to invest in more real estate. Real estate investing can really beef up your ability to build long-term wealth, but you need to go into it armed with a strong understanding of the risks you’ll be taking on. Below is a snapshot of some of the potential risks and rewards of using home equity to buy an investment property.
Allows you to increase your down payment, which can reduce your monthly payments and the interest you’ll pay long-term.
Generates passive income, which you can use to repay the loan and benefit from for years to come.
Increases your vulnerability to fluctuations in the housing market. If the market goes south, shrinking home values could put you underwater or make it difficult to sell.
Stores all of your eggs in one basket. Since both houses are tied up in loans, if anything goes wrong you could lose both houses to foreclosure.
Home equity loan interest payments aren’t tax-deductible unless used to fund home renovations.
Higher education expenses
The national student debt load is about $1.6 trillion, according to data from the Federal Reserve Bank of New York, and the average debt balance for federal and private student loans is around $40,000. That’s a ton of money for almost anyone, but homeowners with college-aged kids may have a distinct advantage: They can leverage their home equity to help fund higher education expenses.
As a parent, you may be more than willing to access your home equity to help your student pay for school or repay their student loan debt. Either way, you could improve your child’s quality of life and help them reach educational goals that can lead to an increase in their future earnings.
If you’re struggling to cover your outstanding medical bills, your available home equity could provide some relief. By tapping your equity to erase your medical debt, you can escape incessant harassment from debt collectors and work toward reversing any negative effects to your credit score.
This is especially true if you’re considering using high-interest credit card debt to cover medical bills. If you instead rely on your home equity, you may secure a lower interest rate and monthly payment in the process.
Depending on how much non-mortgage debt you have, it might be beneficial for you to use your home equity for debt consolidation.
For example, if you have several thousand dollars in credit card debt, at an average interest rate of 21.59%, your balance could eventually become too challenging to tackle. For comparison, medium-term (10-year) home equity loans and HELOCs have average interest rates of 5.02% and 5.51%, respectively.
Be mindful that this option for leveraging equity is only a smart move if you refrain from racking up more debt after it’s paid off — otherwise, you’ll create more bills for yourself.
It may sound less sexy than other home equity products, but a simple refinance can achieve a lot. Most refinances will get you into a new loan with better interest rates and/or lower payments than you had with your purchase mortgage. You also have the option to choose a shorter loan term, which can result in huge savings over the life of your loan. Finally, if you’ve reached at least 20% home equity, a refinance is a great way to get rid of annoying private mortgage insurance (PMI) payments.
3 worst ways to leverage equity in your home
Home equity can help you achieve your financial goals, but it only works in your favor if you use it wisely. Avoid tapping your equity for any of the following purposes.
SPLURGING ON VACATIONS
Sure, exploring Tahiti sounds like an unforgettable experience, but you should do that on your own dime. Why create a new monthly bill for years on end just to finance one week away? Remember, your home is being used as collateral when you access your home equity — and if you can’t make your payments, you’re at risk for foreclosure.
COVERING EVERYDAY EXPENSES
If you’re finding it difficult to manage your monthly bills already, taking on more debt creates a larger problem. Instead, contact your lender to request a mortgage forbearance or a loan modification if you’re facing a temporary hardship and worry about falling behind on your home loan payments.
INVESTING IN DEPRECIATING ASSETS
Think twice about using your home equity to buy a brand-new car or new furniture. These items depreciate in value over time, and you can lose your home if you can’t keep up with the home equity loan or HELOC payments.