As home prices continue to rebound from the recession, home equity loans are becoming sources of extra cash for a growing number of homeowners.
But tapping the value of your home is something that should be done cautiously and for a very few number of reasons.
A decade ago, way too many homeowners were yanking cash out of their homes like they were bottomless piggy banks to fund affluent lifestyles they couldn't really afford. Those reckless borrowers paid the price when the housing bubble burst, property values plunged and they lost their homes.
So, if you're thinking about taking out a home equity loan or line of credit today, take a savvier, conservative approach.
Smart move 1. Choose the type of loan wisely.
There are two ways you can borrow against your property:
- A home equity term loan lets you borrow a lump sum and pay it back over a fixed term at a fixed interest rate (like a mortgage or car loan).
- A HELOC (home equity line of credit) works more like a credit card. It makes a certain amount of credit available on an as-needed basis for a limited term. For example, you have five or 10 years to draw on the line of credit. After that time, the complete balance will fall into a repayment period as determined by your initial term. Keep in mind these also have adjustable rates that change with the market and some products may have early pre-payment penalties and annual fees that could be charged to you.
A home equity term loan makes sense if you need a large amount all at once for a specific project.
A HELOC might make more sense if you need to borrow smaller amounts over a longer period.
You might be tempted to choose a HELOC because of its lower interest rate. But since today's interest rates have almost nowhere to go but up, a HELOC's variable interest rate could end up costing you much more over the loan term than a home equity loan's fixed rate, even though the fixed rate is higher initially.
Smart move 2. Make sure you know how the loan works and what the payments will be.
Whichever type of financing you choose, home equity rates are very attractive right now.
- While rates may fluctuate in your community, nationwide the average cost of a $30,000 HELOC is 5.2%.
- The average cost for home equity loans has fallen from a high of 6.24% in 2015 to 5.21% today.
Since home equity loans have a fixed interest rate and term, you can use the loan payment calculator to help figure out your repayment plan.
HELOCs are more difficult to predict because the interest rate changes over time and they usually offer some flexibility in how you repay them.
Most HELOCs require low payments for the first 10 years while the line of credit is open to use. But in the 11th year, the line of credit is closed, and the principal must be repaid over the next several years.
A better option is to pay back the loan quickly to minimize the amount you pay in interest, get rid of the monthly payment and eliminate the risk of having your home as collateral for a secondary purchase.
Smart move 3. Limit your use of equity.
During the housing bubble, consumers used home equity borrowing to pay for everything from boats and exotic world vacations to cars and kitchen renovations.
The problems these homeowners experienced during the financial crisis and recession taught us that even some "not so bad" spending should be scratched from our list of acceptable uses.
So, while some financial advisors used to say that financing a car with your home’s equity was OK, most no longer believe that.
Besides, auto loans are now one of the few types of consumer loans that are cheaper than home equity loans or lines of credit.
With rising college tuition and borrowing costs, you might be tempted to use home equity to pay for your child's tuition. The interest rates can be lower than those on student loans, especially private student loans and PLUS loans. And, if you're considering putting part of a semester's tuition on a credit card and carrying a balance, using a HELOC to manage short-term cash flow is a much better option.
Smart move 4. Use equity to cut your interest payments.
Finally, it still makes sense to use a home equity line to pay off all of your high-interest credit cards and repay that debt at the home equity’s lower interest rate.
You'll get out of debt faster by taking all (or at least most) of the money you needed to keep up with your credit card bills each month and paying back your home’s equity instead.
(Of course, you must refrain from running up big balances on your credit cards again, or you'll defeat the whole purpose of the home equity line.)
Our debt consolidation calculator shows how much you can save and how quickly you can become debt-free.
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