As tappable home equity rises, you may be tempted to turn your equity gains into cash with a home equity loan or cash-out refinance. Homeowners saw equity increase by 34% in the last year to an average of $207,000 per borrower, according to Black Knight, a mortgage technology and data provider. But before you tap your home equity, consider the best way to use it.
A common, and clever, use of home equity is for home improvements. But can home equity also be a good source of funding for starting a business, purchasing more real estate or taking a long-awaited vacation? Generally, the best use of home equity is to add value to your home or to improve your financial picture.
Read on to learn more about the best ways to use a home equity loan and when borrowing against your home could spell disaster.
[Read: Best Home Equity Loans.]
What’s a Home Equity Loan?
A home equity loan allows you to borrow a lump sum against the equity you’ve built in your home. Home equity is the difference between how much you owe on your mortgage and how much your home is worth. With a home equity loan, you turn that equity into cash you can use now rather than later, when you sell your home.
You can access your home equity with a home equity loan, a cash-out refinance or a home equity line of credit, also called a HELOC. Whether you choose a home equity loan or a HELOC, you can generally borrow up to 85% of your home equity. The amount you can borrow with a cash-out refinance is capped at 80%.
Expect to pay about 2% to 5% of your loan amount in closing costs, in addition to your interest rate.
Reasons to Tap Home Equity
Home equity loans typically have low rates because they are secured by your property, and they allow you to borrow large amounts of money against your home. A home equity loan can give you a lot of buying power to achieve goals such as starting a business, paying for college or upgrading your home.
This type of loan can be a good alternative to higher-interest unsecured financing options, such as credit cards or personal loans. Just make sure you have a good plan for using your home equity.
“Equity loans or lines are extensions of credit, so if you have a need for the extension, then sure, use it,” says credit expert John Ulzheimer, formerly of FICO and Equifax. But don’t bother if you don’t need to take on new credit, he says.
[Read: Best Home Improvement Loans. ]
What Can a Home Equity Loan Be Used For?
You can use a home equity loan for nearly anything you’d like, but not every idea is a good one. These are some of the best ways to use your home equity:
1. Improving Your Home
One of the most common ways to use a home equity loan is for home improvements, says Dave Krichmar, a Houston mortgage banker. Recently, “The absurd jump in equity encouraged a lot of people to cash out to do projects they might otherwise not afford,” he says.
Home improvement projects can make your place more comfortable to live in and increase its resale value, which can pay off when you sell. Understand that you’re not likely to see a 100% return on investment from any home improvement, though.
“To the extent you can use the value of your home to further increase the value of your home, that makes perfect sense,” Ulzheimer says.
You can also deduct interest on your home equity loan, but only if you use it “to buy, build or substantially improve” the home that secures the loan, according to the IRS.
2. Consolidating Debt
Home equity could help you pay off high-interest debts such as credit cards and loans at a lower rate over a longer term, reducing your monthly bills and total interest costs.
“The best scenario would be to use a cheaper equity loan to pay off more expensive debt,” Ulzheimer says.
Using home equity to wipe out credit card debt can make a big difference in your day-to-day financial life, Krichmar says. Maybe your credit card bills are daunting at $1,000 a month, but a home equity loan that pays them off and adds just $200 to your monthly mortgage payment is manageable.
A word of caution when you are using home equity to pay off debt: You’re turning unsecured debt into secured debt. Be sure you can make the payments and won’t run up new debt, because your house is on the line. First, try options such as saving or cutting spending before you take out home equity for debt consolidation, Krichmar says.
3. Starting a Business
If you’re sitting on a lot of home equity, you could turn it into a source of funding for a new business. A home equity loan likely has a lower rate than a business loan.
Using home equity to invest in real estate is popular, as some homeowners turn equity into a down payment — or a full purchase — for an investment property. Krichmar is a fan of this approach and has done it himself, cashing out equity from his house to put down on a rental property.
But remember that no business has a guaranteed return on investment. You could lose some or all of your money and still have to pay back the loan. And if you default on your home equity loan, you could lose your house.
4. Paying for College
Higher education, whether for yourself or your children, can be a good investment in the future. College costs can be prohibitive in some cases, and families may not qualify for the financial aid they need.
A home equity loan can be a good alternative to private student loans, especially if interest rates for home equity loans are lower than those for student loans. If you select a longer term for your home equity loan, you could get a lower monthly payment than with a student loan.
Before tapping home equity, max out any federal financial aid available to you. If you’re paying for college with a home equity loan, you won’t get all of the benefits of federal student loans. In the last few years, borrowers have seen student loan relief and the potential for widespread federal student loan forgiveness looms.
If you’re using home equity to pay for a child’s college education, do not overextend yourself.
Make sure the payments won’t slow your retirement contributions or put your home at risk. A student loan may be a better idea because your child has many more income-making years ahead to pay it down.
5. Funding an Emergency
If you don’t have an emergency fund to cover three to six months of living expenses, a HELOC could be your safety net while you save up.
With a line of credit open, you have funds available to cover unexpected home repairs or medical bills. And as you repay your HELOC, the line of credit will return to its full value. Just be sure you can pay back your HELOC before you borrow against your home for emergencies, and work on building your savings.
[Read: Best Private Student Loans.]
How Not to Use a Home Equity Loan
The worst place to put your home equity is for short-term uses, Krichmar says. That can include:
— Daily expenses.
— Market investments.
— Loans to family members or friends.
The benefit should outweigh the cost, Krichmar says. If you’re taking out a small home equity loan, look closely at the fees. If they are too high, they could make the cost outweigh the value of taking cash out of your home.
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