7 Home Equity Rules to Live By
As housing prices continue to rise across the U.S., an increasing number of consumers are looking for ways to tap into what is often their greatest source of wealth – their home equity. With a home equity loan or a home equity line of credit, homeowners are able to borrow against their home’s value without selling their property or getting a new primary mortgage.
Home equity loan amounts peaked nationally in May 2009 at more than $611 billion, according to the Federal Reserve Bank of St. Louis, and American consumers still hold $350 billion in home equity debt as of November 2018. This goes to show that, no matter the economic climate, home equity loans continue to remain popular with consumers who want to tap into their home’s equity to achieve myriad personal and financial goals.
You can use a home equity loan for a number of reasons — from making home improvements to consolidating debt or paying for a major expense. But it’s not always a smart borrowing option depending on your circumstances.
What are the pros and cons of tapping into your home equity? And, what can you do to ensure you’re using your home equity in the most advantageous way possible? Last but not least, which pitfalls should you avoid as you shop around for a home equity loan?
This guide was created to answer those questions while also providing some basic “rules” you should consider as you decide on a home equity loan.
But first, let’s talk about what home equity loans are — and what they aren’t. Home equity loans are loans you borrow against the value of your home. These loans typically come with a fixed-interest rate, a fixed term, and a fixed monthly payment. Because of this, home equity loans make it easy to know exactly when you’ll pay them off and become debt-free.
Now that you know how home equity loans work, here are some of the rules to live by as you move through the loan process:
Rule #1: Consider all your alternative lending options
The first rule to recognize as you shop for loans is the fact that you don’t have to get a home equity loan at all.
There are several different loan options that can help you access the cash you need, although not all of the alternatives use your home equity as collateral.
Depending on your situation, the following loan options might also help:
- Home equity line of credit (HELOC). A HELOC works similarly to a home equity loan as it uses the equity in your home as collateral. However, HELOCs are a revolving line of credit and not a traditional loan. Because HELOCs let you borrow only the amounts you need up to your credit limit, you don’t have a set payoff amount or a set payment date. Most HELOCs also have a variable interest rate instead of a fixed rate.
- Cash-out refinance. If you’re determined to borrow against the equity in your home, you could also consider a cash-out refinance. With this strategy, you would take out a new mortgage for a larger amount and pay off your old one, keeping the difference in cash for yourself. Typically speaking, you can only borrow up to 80 to 90 percent of your home’s value with this method.
- Personal loan. Personal loans are similar to home equity loans in the fact they usually come with a fixed term, a fixed interest rate, and a fixed monthly payment. The big difference is these loans are unsecured, whereas home equity loans use your home as collateral. While interest rates on personal loans vary, they may be higher than rates on home equity loans since these loans are unsecured.
Rule #2: Understand tax rules
Now that you know what some alternative loan options are, it’s crucial to dig into the nitty-gritty of home equity loans. This is especially important now since the new tax law implemented in 2018 drastically changed the way home equity loans are treated at tax time.
According to New Jersey tax attorney Brad Paladini of Paladini Law, borrowers with home equity loans and HELOCs were previously able to deduct the interest on loan amounts up to $100,000. After the new tax law came into play at the beginning of 2018, however, you can no longer deduct the interest on home equity loans or HELOCs for the following tax season in most cases. Paladini also notes that there is no grandfathering provision. So, if you have an existing home equity loan, you can no longer deduct your interest regardless of when you borrowed the money.
Paladini does list a few exceptions where you may be able to deduct the interest on a home equity loan, however. Because the IRS looks at “acquisition indebtedness” differently, you can deduct the interest on a home equity loan if it’s used to acquire or update a property. In other words, you can still deduct the interest on home equity loans used for major updates or improvements to your home.
Paladini says home equity loans used for business purposes, such as a landlord borrowing money against their own rental property would still be tax-deductible as well.
Rule #3: Long-term debt + short-term expenses = disaster
While home equity loans can be advantageous if you need access to cash and have plenty of home equity, this doesn’t make these loans a smart option to cover all types of expenses. In other words, the fact you can borrow against the equity in your home doesn’t mean you should.
Keep in mind that borrowing against your home equity isn’t free. You’ll pay interest on your home equity loan just as you do on a traditional mortgage. Not only that, but borrowing against your home equity means you’re agreeing to pay off your home at a slower pace and stay in debt longer.
With all this in mind, it’s easy to see why you probably wouldn’t want to take out a home equity loan to cover “wants” or splurges you haven’t saved up for.
If you use proceeds from a home equity loan to cover a luxury vacation or a new wardrobe, for example, the debt you take on can affect the rest of your life, including your ability to save, borrow and make purchases.
Also, David Gorman, a west division executive of Bank of America notes that if your debt begins to impact your credit score, you may also pay more to borrow money via a higher interest rate on other loans, such as car loans or personal loans.
Plus, you have to remember that the costs of borrowing can impact your finances substantially — especially if you’re not meeting your other financial goals.
“The money you pay in interest could instead be going toward an emergency fund or everyday items,” said Gorman. That’s why, when it comes to short-term “wants,” it’s important to look at your finances from a holistic perspective.
“It’s important that planning to save for a home and for retirement doesn’t take a back seat to shorter-term needs,” said Gorman. There’s nothing wrong with splurging for a fancy vacation or buying new furniture, but you should strive to save up the cash for these short-term desires if you can.
Rule #4: Know when long-term debt makes sense
While borrowing against your home equity for lifestyle purchases or vacations isn’t a good idea, there are situations where taking out a home equity loan or HELOC can be a smart move, says Gorman. These loans can even be a valuable tool when it comes to financing big-ticket items, like major home improvements and education expenses, he notes. If you use the funds from a home equity loan to make significant updates to your property, for example, you may see your property value rise congruent with your indebtedness.
Many homeowners use home equity loans or HELOCs to incorporate energy-efficient home upgrades that can save enough money over time so that they pay for themselves, says Gorman.
“Energy-efficient upgrades also increase a home’s comfort level and make a home more appealing for future sale,” he added. As an example, Gorman notes how the 2017 Cost vs. Value report from Remodeling magazine found that the average fiberglass attic insulation cost was $1,343, yet the average value added when it came time to sell was $1,446. Not only does adding insulation help with resale value, but there’s a good chance homeowners would see lower utility bills while they remained in the home, too.
Gorman notes that there are other situations where HELOCs and home equity loans make sense, including debt consolidation and education expenses. Generally speaking, these loans remain a good value as long as interest rates remain lower than what many consumers get with other types of loans.
Rule #5: Keep your total home loan debt below 80 percent of your home’s value
If you’re thinking of borrowing money with a home equity loan, you may be tempted to extract every dollar of cash that’s available. However, you should think long and hard before you borrow more than you need. While you may be able to borrow a home equity loan for up to 95 or even 100 percent of your home’s value, there are several reasons you should strive to keep your total home loan debt below 80 percent.
Those reasons include:
- You want to avoid PMI, or private mortgage insurance. Private mortgage insurance is a type of insurance coverage you may need to pay for if you buy a home with less than a 20 percent down payment. While PMI amounts vary, this coverage usually costs between 0.15 to 1.95 percent of the loan amount each year. To avoid PMI completely, you need to make sure you put down at least 20 percent when you purchase your home. Then make sure you maintain at least 20 percent equity in your home if you choose to refinance.
- You may want to sell one day, and you’ll wish you had a financial cushion. While you may plan to stay in your home forever, you never know what life will throw your way. Maybe you’ll get a new job that requires you to relocate. Or, perhaps you’ll expand your family and need more room. Either way, having at least 20 percent equity in your home will ensure you’ll have money to pay a realtor to sell and market your home, along with a profit when you sell.
- Property values can drop. While most of us hope our properties will only grow in value, life doesn’t work that way. The housing crisis of 2008-2009 taught us how it’s possible to lose a significant amount of your home’s value in a short amount of time. By maintaining at least 20 percent equity in your property, you’ll put yourself in a better financial position if housing prices were to drop.
Rule #6: You need to shop around
Gorman notes that the more home equity you have, the more financing options you’ll find at your fingertips. This includes both home equity loans and home equity lines of credit (HELOCs), along with the possibility of a cash-out refinance.
Like any other purchase you make, it’s important to shop around when it comes to home equity loans. For starters, Gorman says that you should find out if there are any fees associated with home equity loans or HELOCs you’re considering. There may be upfront fees, such as an application fee, an annual fee, and a cancellation or early closure fee, he notes. However, some lenders don’t charge these fees or any others.
In addition to comparing fees, you’ll also want to make sure you compare interest rates offered through various banks and other lenders.
If you’re angling to get the best deal on a home equity loan possible but don’t want to do all the legwork, check out LendingTree’s easy-to-use interface. You can fill out a short online form and possibly compare loan options from more than one lender. Better yet, you can do this all online without ever leaving your home or driving from bank to bank to get separate quotes.
Rule #7: You need a payback plan
Whenever you borrow money, it’s important to have a plan to pay it back. Not only will having a plan in place before you borrow help you determine whether you can afford the loan in the first place, but it will help you stay on track to repay your loan and get out of debt in the end.
Because home equity loans offer fixed interest rates, fixed monthly payments, and fixed terms, they make it easy to figure out whether you can afford to borrow the money you need. If you’re curious what your loan amount would be based on the amount of cash you want to borrow, a home equity calculator can be a valuable tool.
Once you know what your fixed monthly payment would be, it’s crucial to make sure you can afford the monthly bill in addition to all your other expenses. At this point in the process, it may help to sit down with all your bills and pay stubs to determine how much you earn each month, how much your monthly expenses are and how much is leftover each month.
While you’ll want to make sure you can afford the minimum payment on your home equity loan, you should also know that it’s possible to pay off your loan faster if you pay slightly over the minimum every month. At the very least, however, you should make sure you can afford the minimum payment on your home equity loan with no problems.
Borrowing against the equity in your home can be a smart move if you qualify for a low-interest rate and convenient loan terms. However, you should make sure you’re not borrowing for lifestyle purchases that will lose their value quickly, and that you have a plan to pay your loan back.
While home equity loans can be valuable tools when it comes to your finances, borrowing money for any reason may cause your finances to spiral out of control if you don’t tread carefully. The bottom line: Make sure to borrow only what you need and what you can afford to repay, or don’t borrow money at all.