Home equity loans have traditionally been an accepted way to pay for home improvement projects or even college education. However, in the past decade, homeowners have been tapping into their home’s equity in order to finance vacations, cars, and other non-investment purchases. Since the collapse of the housing bubble, homeowners lucky enough to qualify for a home equity loan are less likely to use equity for frivolous purchases. They may also feel gun shy about home equity loans in general, for fear of getting in over their heads. Here’s a quick breakdown of what to expect from a home equity loan and why you might want one.
While these two methods of tapping the equity in your home are similar, it’s important to know the difference between the two.
A home equity loan is set up more like a traditional mortgage, where you pay back the loan over a set period of time, usually with fixed rates and payments.
A home equity line of credit, or HELOC, on the other hand, is more like a credit card. You are allowed to borrow a certain pre-approved amount against your home’s equity, and if you pay off some of that debt, you have freed up more credit that you can then spend. You are given a borrowing limit and cannot go above that on the HELOC. Payment schedules are somewhat different for lines of credit — you generally have a set amount of time during which you may draw from that line of credit, and you are responsible for paying off the debt after that point. Interest rates on home equity lines of credit tend to be variable, but are tied to the prime lending rate.
Home equity loans are best for when you need a large amount of money that will take you several years to pay off. The interest rate will be fixed, as will the monthly payment, so there should be no surprises with a HEL.
The traditional uses for a loan are still the best reasons for tapping into your equity. If you want to undertake some major home improvement, it makes sense to use the equity in the home to do so. Theoretically, the money you put into your house will be money you can get back out again when you sell. However, it is still important to remember that not all home improvement projects will bring a return on investment — putting $40,000 into a new addition will not necessarily make your house worth $40,000 more. You might only get $20,000 or $30,000 back off of what you spent. As long as you keep your expectations and expenses reasonable, it does make sense to use your home’s value to improve your home.
The other accepted use for a HEL is college education. Like home improvement, education is supposed to be an investment that will help guarantee future money. Unfortunately, with the incredible costs of education and the difficulty recent graduates face in finding a job, this is an avenue you must approach with caution. It may be wise to avoid high priced universities and stick to local community colleges or in-state universities.
Using a loan to pay off credit card debt, to purchase a vehicle, or to go on vacation may sound like great ideas, but they could leave you in a bind. The rule of thumb is that anything you use an HEL to buy should be still around and worth at least what you paid for it by the time you’ve paid off the loan.
Lines of credit are ideal for homeowners who either need a shorter-term loan or who would like to have credit available for emergencies. You can keep the line of credit open and available without actually owing the bank any money, although you will want to make sure you’re aware of fees, rates, and other stipulations if you do use your line of credit as an emergency fund. There may be a charge just to have the line of credit open.
Like the traditional home equity loan, the line of credit should only be used if you know that you can pay the money back. Despite what it may seem like, your house is not an endlessly refilling piggy bank. You want to keep at least 20% of your home’s equity right there in your home. Otherwise, your home is not an asset and you won’t be able to use your home’s equity to trade up when you’re ready to buy another house, or to help fund your retirement if you’re ready to get out of home ownership. At worst if your home’s value falls and you have little equity, you may not be able to sell the home at all without coming to closing with thousands of other dollars.
Tapping into your home’s equity is a financial tool worth looking into — but also one you will want to be cautious with.
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