If you’re wondering, “What is home equity?” or “What is a home equity loan?” — then you’ve come to the right place. Here’s a basic home equity definition: The equity you have in your home amounts to the difference between the value of your home and the amount of money you still owe on your mortgage. If your house appraised for $200,000 and you paid off $100,000 of your mortgage, you have $100,000 in equity. Equity can be used as collateral for a home equity loan or a home equity line of credit.
Home equity loans, often called second mortgages, are lump-sum loans with fixed interest rates. A HELOC is more like a credit card: Although it’s also secured by your equity, you can draw from it over time when you need to.
Whether you have a home equity loan or a HELOC, if the market value of the home falls below the amount of the loan, you’ll find yourself in a negative-equity situation. Most lenders don’t allow homeowners to borrow 100 percent of the equity in their real property home values; the typical amount is limited to around 85 percent.
5 Best Ways to Use Home Equity
You build equity when your home appreciates naturally over time, you pay down your mortgage principal or make home improvements. Equity is one of the biggest benefits of homeownership, and you can leverage it. Here are the five best ways you can use home equity:
1. Make Home Improvements
Making home improvements is one of the best ways to use equity because those improvements can build more equity. When you leverage your equity to increase the value of your home, you can sell it for more than you otherwise would have, or borrow more in the future once you pay back the loan. Smart upgrades include kitchens and any improvements for energy efficiency.
2. Consolidate Debt
Home equity can help you take control of personal debt. For example, there are several advantages to using a home equity loan to pay off multiple high-interest credit card debts. You’ll face only one fixed monthly payment, and since home equity loans generally carry lower interest rates than revolving credit card debt, that payment is likely to be much more attractive.
3. Pay for College
Harnessing the equity in your home can be a smart way to pay for college. You must consider several variables including the length of the loan and the interest rate. Because many parents face their own retirement within five or 10 years of financing a child’s education, this is a personal decision that varies by case. You might consider a blended approach, leveraging equity and utilizing education-specific loans or government programs.
4. Finance an Investment Property
You might consider using the equity in your home as a down payment to purchase, rehabilitate or renovate a second property you can rent for supplemental income. Investment properties can provide financial security and independence, but only if they earn enough rent to cover the loan. If the investment fails, you’re still on the hook for the home equity loan and you might risk losing your primary residence.
5. Use for an Emergency Fund
Having an emergency fund is a critical piece of the financial security puzzle. You should have several months’ worth of readily available money saved in an interest-bearing account. For many, that’s simply not realistic. In some cases, a HELOC is a smart way to gain quick access to money if you have an emergency, and you can pay it back over time.
5 Worst Ways to Use Home Equity
Home equity loans and lines of credit come with risks. They carry interest, and if you default on the loan, you could lose your home. Although equity can be a powerful tool, it isn’t always the answer. Here are five ways you shouldn’t use home equity:
1. Buy a New Car
Homes are appreciating assets, meaning their value generally increases over time. You shouldn’t use home equity to pay for depreciating assets like cars, which begin losing value the moment you buy them. Don’t be tempted if a home equity loan or HELOC has a lower interest rate than a traditional auto loan. Auto loans are secured by the vehicle — if you default you lose only your car, not your home.
2. Take a Vacation
It’s always nice to go on vacation and get away from home — but not at the expense of possibly losing your home. No matter how badly you need a vacation, a vacation is a short-term want — one you shouldn’t finance with money that could cost you your home. Instead, use a traditional line of credit or take a cheaper vacation.
3. Invest in the Stock Market
Wise investments can lead to lucrative gains, but even the safest investments come with risks. Some investors might be tempted to borrow against their homes because home equity rates are typically lower than the average market returns. Those averages, however, are measured in decades. In the short term, market downturns are always a possibility, and when investors use equity to play the market, they risk losing out on both the investment and their homes. It might be better to save money in an interest-bearing account rather than risk it to a volatile stock market.
4. Buy Luxuries
Living within your means involves going without certain luxury items. If you want something you don’t need and can’t currently afford, save money, look for bargains, or wait for sales deals — but never risk losing your home by borrowing against your equity for things you can live without.
5. Take Out a Loan Before You Sell
The outstanding balance on all debts against your home must be settled before you sell it. If you’re planning to put your home on the market, it’s not a good idea to borrow against the equity in it. And don’t take out a home equity loan to make home improvements before you sell, either. Instead, use cash on hand or other available credit to make whatever improvements you can before listing your home.
Keep Reading: 25 Tricks to Sell Your House for a Bigger Profit
Every time you pay down your mortgage or increase the value of your home, you build equity. Equity is one of the biggest benefits of owning a home and a reliable key to a homeowner’s financial security. Equity can be a powerful tool — if you use it wisely and for the right reasons. Understand your home equity loan requirements and loan rates — and use a home equity calculator before you sign.