Home equity Financing

Equity in your home is an important resource. It may be your largest single asset, and beyond that, it can be a source of relatively low-cost financing. Given its value, it is vital that you understand how to use home equity wisely.

How to Use Home Equity

You have multiple options for accessing home equity, and it is a cost-effective way of borrowing. What can you use this money for? Think primarily in terms of three major categories:

  1. Reinvesting in your home. This can include home improvements such as repairs, upgrades, or additions -- anything that adds lasting value to the property.
  2. Cost-effective long-term financing. Whether it is an educational, auto, or personal loan, if you need long-term financing and you have home equity at your disposal, compare the (after tax) interest rates for home equity loans with those of other types of credit. Home equity financing may be the cheapest.
  3. Debt consolidation. If you have run up debts at higher interest rates, using a home equity loan to pay off those debts can both lower your interest expense and make repayment more convenient. However, this should not be used to simply facilitate further borrowing, because your house is on the line if you cannot repay your home equity loan as agreed.

There are dozens of other potential uses for home equity, but as a rule you should not take out a long-term loan for short-term purchases. If the payments are going to last longer than the useful life of what you are buying, you are practicing spending habits that can lead to continually running up debt faster than you can pay it off.

Using Home Equity Without Using it Up

With any loan, but especially one that is secured by your home, it is important to have a plan for repayment before you borrow. Take a look at a payment schedule, making sure it fits comfortably into your monthly budget and that your sources of income are reasonably certain.

Knowing how to use home equity is important. Even more important is knowing how not to use it -- do you really want to spend the next 20 years paying for a two-week vacation? Treat home equity like it's your retirement, children's college fund and emergency nest egg all at once -- because that's exactly what it is -- not something to be spent lightly. With this approach to using home equity without using it up, you can have the best of both worlds -- a ready source of cost-efficient financing, plus a steadily declining debt burden.

Accessing Home Equity

Home equity is the difference between the current value of your home and the total of its mortgage balances. When you borrow against home equity, it becomes security for the loan, and it is this security that gives lenders the confidence to make these loans at relatively low interest rates.

There are three major ways to access home equity:

  1. Home equity loan. Also known as a "second mortgage," this loan delivers a lump sum of cash at closing and is repaid in monthly installments. It usually (but not always) comes with a fixed interest rate. This is the best solution for financing one-time expenses like debt consolidation, a large investment or a big-ticket purchase like a motor home.
  2. Home equity line of credit (HELOC). This revolving account is a line of credit (like a credit card) secured by your house. You only pay interest (usually a variable rate) on the amounts you use. However, there may be setup and maintenance fees. This approach makes the most sense when you need money over time -- like paying college tuition, financing a series of home improvements, or providing a source of emergency cash for your business. 
  3. Cash-out refinancing. A third way of accessing home equity is to refinance your current mortgage with a larger loan, and take the difference in cash. The excess amount is borrowed against equity you have built. This approach makes the most sense when interest rates have fallen, so you can both access home equity and get a lower interest rate for the entire amount that you owe. Understand, though, that cash-out refinancing comes with higher costs than regular rate-and-term refinancing. Cash-out refinancing generally makes sense only when the amount needed is very large.

The right method for you depends on the interest rate environment, the amount you need and how you intend to use the money. The next section looks at some options for how to use home equity.