5 Smart Ways to Leverage Your Home Equity
While rising home values are a plus for homeowners who decide to sell, owning a home that’s growing in value can be a boon for those who stay put, too. When your house is worth more than you paid, you have a growing asset you can leverage in lean times.
Of course, the spoils of home equity also go to those who diligently pay down their mortgage balances over time. The less you owe, the more equity you can access when you’re ready.
If you’re a homeowner with equity and want to use it to your advantage, it’s important to know the ins and outs of home equity loans. With the right outlook on debt and a solid plan to use your equity smartly, you could borrow against the value of your home for a number of important projects without impeding your long-term financial goals.
- What is a home equity loan?
- 5 smart ways to use a home equity loan
- Using home equity for home improvements
- Using home equity for higher education expenses
- Using home equity loan to consolidate credit card debt
- Using home equity for medical expenses
- Using home equity for a down payment on a second home
- The bottom line
What is a home equity loan?
Before you apply for a home equity loan, you should understand how they work and what to expect. In short, home equity loans offer fixed interest rates, fixed repayment terms, and fixed monthly payments. However, unlike unsecured personal loans, home equity loans are secured by the equity you have in your home.
While home equity loans sound like a good deal — and they often are — it’s important to understand that not everyone can qualify. Not only do you need a very good or excellent credit score (a FICO score of 740+) to qualify for a home equity loan with the lowest interest rates and best terms, but you need considerable equity in your home, too. Generally speaking, the amount you can borrow is limited to 85% of the value of your home. However, your income, credit history and the value of your home can also affect the amount you can borrow.
5 smart ways to use a home equity loan
The good news about home equity loans is that once you borrow the money, you can use it however you want. At the same time, some of the possibilities will leave you better off than others.
For example, while you can use a home equity loan for a bucket-list vacation to some far-flung corner of the world, you should decide whether borrowing money for a splurge is the right choice.
As you explore the possibility of borrowing against your home equity, make sure you consider the long-term implications of taking on debt. With that in mind, here are some of the smartest ways to leverage home equity.
Using home equity for home improvements
Using a home equity loan to cover home improvements can be a smart move, although it depends on the improvements you make. If you use the money to make upgrades or repairs that are desperately needed or will improve the value of your home, for instance, then borrowing against your home equity could wind up being a financially savvy move.
Remodeling Magazine’s 2018 Cost vs. Value Report offers statistics that can help you figure out whether certain remodeling projects may be worth it based on where you live. On a national level, replacing a garage door can provide a 98.3% return on investment within a year, their numbers show. Manufactured stone veneer, on the other hand, brought home values up 97.1% when installed in 2018.
Of course, there are times when a home upgrade is crucial regardless of whether you intend to sell or need to recoup your costs. If you desperately need a new roof to avoid leaks and pricey repairs later on, for example, then that would be a smart way to use home equity, no matter how much value it adds to your home.
Pros of using home equity for home improvements:
- Interest rates on home equity loans may be lower than other options. If your alternative is using a credit card for home improvements, then a home equity loan is likely a better deal, says Ralph DiBugnara, VP at Residential Home Funding. “With credit card interest rates teetering around 15%, you’d be smart to use a home equity loan instead,” he said.
- You could recoup your investment later on. If the home upgrades you make add value to your home, you could get your money back with a higher selling price when you go to sell.
Cons of using home equity for home improvements:
- You could overdo it. Sandra Shaud, a 31-year veteran of the mortgage business, says she has seen too many people use home equity to over-improve their homes with disastrous results. “Just because you can borrow $50,000 for home upgrades doesn’t mean your home will gain any value,” she said.
- You may need more money then you can borrow. Shaud says she has also seen many couples take out home equity for a home remodeling project only to run out of money before they finish. “Make sure you have a realistic home upgrade budget before you start tearing down walls,” she said. “It’s harder to borrow more money without having to turn to a credit card once you’ve tapped out all your home equity and your home still isn’t finished.”
Using home equity for higher education expenses
The rise of college tuition and fees has left many families wondering how they can afford college. Keep in mind that the average tuition at a four-year public university reached $9,970 nationally for the 2017-18 school year, but that costs rise to $20,770 per year when you include room and board. That’s a ton of money for almost anyone, but families with home equity have a distinct advantage since they can use their equity to help fund tuition costs.
But, paying tuition isn’t the only way families can use their home equity to pay for school. According to the U.S. Department of Education, student borrowers belonging in the FY 2014 borrower cohort (Oct. 1, 2013 to Sept. 30, 2016) defaulted on their student loans at a rate of 11.5%. Meanwhile, the median debt loan for students with a bachelor’s degree was $25,000 in 2016 according to Pew Research Center.
As a parent, you may be more than willing to access your home equity to help your son or daughter pay for school or pay off their student debt. Either way, you could improve your child’s quality of life and help them reach educational goals that can lead to higher earnings later on.
Pros of using home equity for higher education:
- You could secure a lower interest rate. Parents planning to pay off loans for their children anyway could get a lower interest rate by using a home equity loan versus federal or private student loans. However, it depends on the type of student loan and how home equity rates compare. A federal Direct PLUS loan taken out after 7/1/2017 comes with a rate of 7%, for example. You may be able to get a home equity loan with a rate lower than that depending on your creditworthiness, notes DiBugnara.
- You could help your children avoid defaulting on their student loans. If your kids are struggling to pay back loans, accessing your home equity to pay some of them off could help them out of a sticky situation and keep their loans out of default.
Cons of using home equity for higher education:
- You could miss out on important federal benefits. Federal student loans come with important benefits like deferment, forbearance and income-driven repayment programs. If you use a home equity loan in lieu of federal student loans, you or your child won’t have access to these benefits.
- Student loans become your responsibility. College tuition and student loans paid with home equity become the borrower’s sole responsibility. You can ask your child to pay you back later on, but they wouldn’t be required to unless they were a cosigner on the loan, says DiBugnara.
Using home equity loan to consolidate credit card debt
Using home equity to consolidate credit card debt can be a smart move, but that’s especially true if your credit card’s interest rates are high. Consider the fact that home equity loan rates can be as low as about 4%, while the average interest rate on a credit card is around 15%. If you were able to consolidate all your debts at that lower rate, why wouldn’t you?
“If the interest rate is a lot lower then it almost always makes sense,” said DiBugnara. However, he also lists one notable exception — if you’re able to consolidate credit card debt with a 0% interest balance transfer card instead.
Unlike home equity loans that offer low-interest rates and fixed payments, 0% APR cards offer no interest for an introductory term of six to 21 months, he says. “You might want to consider a balance transfer instead if you can qualify.”
Pros of using home equity to consolidate credit card debt:
- You’ll save money on interest. Consolidating all of your high-interest debts into a new loan with a lower interest rate will help you save money on interest. With lower interest charges, it’s possible your minimum monthly debt payment will go down as well.
- You’ll move to a fixed repayment plan. While credit cards tend to come with variable interest rates and flexible repayment terms, home equity loans come with the advantage of having a fixed interest rate, fixed monthly payment, and fixed repayment term. This makes it easier to stay on track and know exactly when you’ll become debt-free.
- You can quit paying multiple debt payments and focus your efforts on one. Consolidating several credit cards into a new home equity loan can help you simplify your finances because you can focus on one payment each month instead of several.
Cons of using home equity to consolidate credit card debt:
- Consolidating debt won’t help you get out of debt unless you’re motivated. Shaud says she’s seen far too many people consolidate debt with a home equity loan but refuse to change their spending habits. “If you keep using your credit cards like you did before, you won’t pay off debt and you could end up worse off,” she said.
- You could stretch out your repayment timeline. While a home equity loan can help you secure a fixed interest rate and monthly payment, you may extend your repayment timeline if you choose this option. While securing a lower monthly payment can be advantageous, Shaud notes this could leave you in debt longer.
Using home equity for medical expenses
If you’re struggling with medical bills you can’t afford or debt collectors are hounding you over medical debt, home equity could be your saving grace. By accessing the equity in your home to pay down or eliminate medical debt, you could escape the constant harassment of debt collectors and gain peace of mind.
This is especially true if you are considering using high-interest credit card debts to cover medical bills. If you use a home equity loan instead, you could potentially secure a lower interest rate and a lower monthly payment in the process.
Pros of using home equity for medical expenses:
- Get rid of stressful bills. “When you’re truly ill, the last thing you should have to worry about is debt collectors,” said Shaud. In that respect, using a home equity loan to pay medical bills could help you gain peace of mind and avoid the stress that could make your recovery that much harder.
- Keep your debt out of collections and protect your credit score. If you can keep your medical bills out of collections by accessing home equity, you should, says Shaud. “Paying your bills with a home equity loan can protect your credit score. Just make sure you can also keep up with the monthly payments on your new home equity loan since your loan is secured by your home.”
Cons of using home equity for medical expenses:
- You may be able to arrange charity care or a hospital-based repayment plan instead. The Consumer Financial Protection Bureau (CFPB) says that many hospitals offer charity care or repayment plans for consumers who can’t pay their bills. These programs can include debt forgiveness or payment plans with little or no interest. Make sure to ask your medical provider to see if these options are available.
- You could lose your home if you don’t repay the loan. Since home equity loans are secured by your home, you have the potential to lose your home if you don’t repay the loan.
Using home equity for a down payment on a second home
While using the home equity in a first home may seem like the smartest way to purchase a second property, there are pitfalls to be aware of, says Shaud. If you’re buying a vacation home but have to use equity from your primary residence to afford it, for example, this could be a sign that you are “in over your head,” she said.
Borrowing against your home equity to buy a rental home is another story, she says. Because a rental home is an investment that can help you earn money, accessing your home equity can make sense. Ideally, you’ll use your home equity as a down payment for a property that returns enough cash to cover the mortgage, property taxes, insurance, repairs and the home equity loan payment, says Shaud.
Pros of using home equity for a second home:
- You could leverage your home equity to build wealth. In the case of buying rental property, you could use your home equity to build wealth through the acquisition of real estate.
- Low interest rates are advantageous. Because home equity loans tend to come with low interest rates, they are often one of the cheapest ways to borrow money.
Cons of using home equity for a second home:
- Your properties could lose value. While it certainly sounds smart to use home equity to invest in real estate, there’s no guarantee your investment will pay off. “Your properties could lose value, which could mean losing more money and still having to pay off your home equity loan,” said DiBugnara.
- Borrowing money can be a risk in itself. “You could easily bite off more than you can chew,” said Shaud. “If you really want to build wealth through rentals or buy a second home, try saving up the money in cash so you’re not taking on more debt.”
The bottom line
Home equity can help you achieve your financial goals, but it only works in your favor if you use it smartly.
Before you take out a home equity loan, make sure you have a plan to cover how you’ll use those funds as well as a plan to pay it back. While borrowing money at a low-interest rate has its perks, borrowing money without a plan or a goal in mind can be disastrous.