Consider the 3 Bs before tapping into home equity
Reasons to tap home equity
- Bad: trendy fashion statement purchases
- Better: paying off unexpected debt
- Best: home improvements
So you’ve got a chunk of equity in your home, and rather than have that cash just sit there, you’ve got the perfect purchase in mind where you could put that money to good use. Right?
Equity is a hard-won return on the investment in your home, and tapping it is not a decision to make lightly, however. If you put your home up as collateral and can’t pay back the loan, you could, in the worst case, find yourself facing a foreclosure action that may lead to you losing your home.
Briefly, there are three ways to tap equity:
- Home equity loan. This is a second mortgage, paid in addition to your original loan. It’s a lump sum payment from a lender that is secured by your home and paid back over a fixed amount of time, with a fixed interest rate.
- Home equity line of credit. Known as a HELOC, this is a revolving loan, similar to a credit card, which also is secured by your home. You are given a maximum limit and you can charge debt, pay it down, then charge that amount again. Loans are for limited terms, and generally have adjustable interest rates.
- Cash-out refinance. This is a method to get a new mortgage by refinancing your existing loan. It is made up of the equity you take out (or cash out) based on your home’s overall market value, plus an amount sufficient to replace what you still owe on the original mortgage that you are refinancing.
Certainly, there are good reasons to get your hands on that home equity. But there are some fairly bad ones too. With that in mind, here are the general three Bs for your consideration before tapping into your home equity: the bad reasons, the better reasons and the best reasons. Consider it fodder for prompting some self-examination before you make an important financial decision.
The following examples of reasons for tapping your home equity are not necessarily bad in every scenario. Still, experts suggest that, in general, you may want to rethink risking your home for reasons such as these. Before you tap the equity in your home for these reasons, first consider making lifestyle changes to address the needs and desires, so you don’t fall back into debt soon after you clear it.
- Pay down credit cards. Probably not the best reason to risk your home if you tend to whip out the credit card on a whim and don’t have plans to change that habit. Consider debt-consolidation options and, more importantly, look for ways to alter spending habits to stay within a budget.
- Fashion statements. While that $10,000, 18-carat gold Ballon Blue De Cartier watch may be stylish, it’s not very practical. Especially if you need to borrow money just to impress a coworker who has a trust fund.
- Enhance your annual ski vacation. If you would normally save money to pay for something, like a vacation or new skis, why borrow money this time? Be honest with yourself about why you’re considering the debt now, and if it’s really that important.
These examples advance some fairly good reasons for making use of home equity, but there may be better options to research before you go down the equity path.
- Pay off surprise debt. We can’t foresee all expenses, like medical bills or major car repairs. Equity for these types of expenses is better than debt for fashion, but it is risky. You could find yourself in foreclosure proceedings if another surprise expense crops up. Consider other options. The hospital may offer payment plans. If the car keeps breaking down, maybe it’s time for a newer car.
- Education. If you can pay the money back in a few years, it’s not a horrible idea. Other things to factor into the decision: Who is repaying the money and how reliable is this person? If you, the homeowner/currently employed person, want to get an advanced degree to help get that promotion, then tapping your home equity may be a good approach. If you, as a parent, want to ship your offspring to a state college, with a strong suspicion that he’ll party out within six months, you might want to rethink using a home-equity loan to cover the costs, especially if you will struggle to make the added payments. A student loan may be a better option.
- Startup business. New businesses are risky, but if you’re dedicated, smart and lucky, you’ve got a shot at success. Still, make sure you have other ways to pay the bills if business is slow, or else you could risk losing your business and your home.
Experts agree these are great reasons for tapping into your home equity. As with any loan, however, remember to shop around for the best rates.
- Home improvements. But only if the projects improve the home’s value. Adding a room or finishing the basement adds usable square footage and generally boosts value. New windows, doors and siding help with curb appeal, as does landscaping, so such upgrades are a good investment. Kitchen and bathroom remodels depend on how long you plan to live in the home, however. If you’re staying, make it yours. If you’re moving soon, don’t go nuts. Most people want to personalize these spaces and may not appreciate your style.
- Major home repairs. The idea of tapping equity to fix a leaky roof, replace faulty wiring or seal up a cracked foundation is second only to dipping into the emergency fund (assuming you can replenish the fund in a timely manner). Major home maintenance and repairs are generally wise investments.
- Accessibility fixes. This is a good idea if you plan to remain in the home into your later years. Consider remodeling the bathroom to install support bars or walk-in showers. Also widen doorways so those with worsening mobility issues can age in place. (Think of using a cane, then graduating to a walker and later a wheelchair).
Do a little honest self-reflection before you tap into that equity. It’s a lot of money that took years to build, so you want to use it wisely.