One of the perks of having worked hard to build equity in your home is that the equity is available to you when you need it. Banks generally allow you to borrow up to 85 percent of your home’s value — including your current mortgage, if you have one, and your home equity loan or home equity line of credit. Whether you should borrow against your equity depends on your immediate needs and your short- and long-term financial goals.
Read on to learn how to get a home equity loan and when to tap into it.
Home Equity Loan vs. HELOC
- Home Equity Loan: A lump-sum, fully amortizing loan that typically has a fixed interest rate, meaning you pay the same amount each month for a fixed number of months; loan terms come in various ranges that include 10, 12, 15 and 20 years
- HELOC: A revolving credit line consisting of a five- to 10-year draw period during which you can withdraw money, up to your credit limit, and make only interest payments, followed by an amortized 10- to 20-year repayment period
Good Reasons to Tap Into Your Home Equity
Your home equity is too valuable an asset to squander, so it’s best to avoid using it for frivolous things like a vacation or luxury purchase. Spending that gives you a good return on your investment is much less likely to lead to buyer’s remorse, whether the return is financial gain or enduring personal satisfaction. Here are six good reasons for tapping into your home equity:
1. Anticipated Financial Emergency
Sometimes you see trouble coming, and if you can take out a home equity loan before it hits, the cash can help you ride out the storm. A HELOC is the better choice for creating an emergency fund because you’ll only have to draw what you need, and you’ll only make interest payments during the draw period.
2. College Tuition
Tuition is an investment in your child’s future, so it might be a good reason to tap into your equity — if you’re far enough from retirement to tie up the equity without putting yourself in a bind, and you’ve exhausted other options. Home equity interest rates tend to be lower than student loan rates, but the interest isn’t tax-deductible when the loan is used for tuition.
3. Debt Consolidation
Home equity loan rates are usually lower than rates for credit cards and personal loans, so paying off higher-interest debt with money from a home equity loan makes good sense. But it’s important to curtail the spending that got you into debt in the first place, or you could find yourself worse off than when you started.
4. Purchase of a Second Home
Owning a vacation home can be enormously gratifying and well worth the expense and risk of a home equity loan. Over time, appreciation and vacation savings might even offset the price. And an investment property’s income can outpace your loan payments and result in positive cash flow right off the bat if you buy wisely.
5. Improve Your Home
Home equity interest is still tax-deductible in many cases if you use the loan money to substantially improve your home. Stretch your budget by choosing the projects that add the most value to your home. On average, a deck addition adds about 83 percent of its costs to your home’s value, and a minor kitchen remodel adds just over 81 percent.
6. Fund Your Business
It’s best to use savings to fund your startup or take your existing business to the next level, but if you don’t have enough, you might use a home equity loan. Have a solid business plan in hand, plus a plan for repaying the loan in the event the business fails to generate the income you anticipated.
Home Equity Loan and HELOC Risks
In addition to putting your home at risk in the event you’re unable to repay the loan, there’s one risk that’s inherent in all home equity loans: They’re typically due in full when you sell your home. This creates a serious hardship if you haven’t reserved enough equity to pay off mortgage balances and cover your seller’s closing costs. In the event you’re unable to cover all these costs with your proceeds from the sale, you’ll have to put off selling or bring cash to closing to cover the shortfall.
Both home equity loan types have additional, unique risks:
- Home Equity Loan: You’ll pay 2 to 5 percent of your loan amount in closing costs. The fee adds significantly to the cost of your loan.
- HELOC: HELOC rates are often adjustable, so they fluctuate over time. And the rates can increase significantly once you enter the repayment phase of a HELOC loan. The rate change can leave you owing more on your home than the home is worth if your home’s value declines during the loan term.
Home equity is an important asset. Although borrowing against it does have risks, it can also help you achieve personal and financial goals.
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