What is home equity? It’s the difference between the current market value of your home and how much you still owe on your mortgage loan. As the value of your home increases, you gain equity in your home.
Because the value of your home as collateral is based on its current market value, a home equity loan allows you to borrow against that equity. You can choose between a home equity loan or home equity line of credit (HELOC).
With a home equity loan you borrow a lump sum amount, usually at a fixed interest rate. A HELOC functions as a line of credit, and like a credit card, you can draw funds as needed up to your available maximum. Your interest rate is typically linked to the prime rate, so when the Federal Reserve raises interest rates, you can expect your HELOC rate to be adjusted accordingly.
A Bankrate.com survey asked why homeowners would tap into their home’s value. Seventy-five percent of respondents said they wanted to use the funds to make home improvements or repairs. Other reasons included consolidating debt (44%), paying tuition/educational expenses (31%), covering household expenses (15%) and funding investments (12%).
Survey respondents said while those were “good reasons” to cash in, they were still a bit hesitant to do so.
According to Bankrate.com, plastic surgery topped the list of worst reasons to tap home equity (45%), with buying a boat (21%) and taking a vacation (18%) rounding out the top three.
Here are a few questions to ask before borrowing against your home.
How much will this cost?
Do your research. Compare interest rates and make sure you understand exactly what is involved. What are the fees? Are there minimum withdrawal requirements? Is the interest rate just an introductory rate? If so, how high could it rise? What are the pros and cons of getting a HELOC or a home equity loan?
Will it improve your financial standing?
A home equity loan is not “free” money. If you are already struggling to pay your bills, adding to your debt by using your home as collateral could lead to disaster. If you can’t make the payments, you could lose your home. Know what you are working with and calculate if this is the right move for you.
What’s my plan?
How do you plan to use your home equity? How can you maximize your return on investment? How will you manage your payments? How long will it take to pay down? With the new tax law, if you are borrowing to make home improvements, you can deduct the interest. If you are trying to pay down your debt with your home, then have a plan on how you will manage your spending moving forward so you don’t dig yourself into a deeper hole.