Could Home Equity Be the Right Choice for You?
Using the equity in your home may seem like an easy and accessible way to fund your next project, but before putting up your home as collateral, it’s important to understand what you’re getting into.
To help you navigate the world of home equity, we put together a guide detailing what requirements you have to meet to even be able to use home equity in the first place, the different home equity options available to you and the five most common and justifiable reasons people opt to use the equity in their homes.
With this information, you can consider your own situation and understand whether or not home equity truly is the right choice for your intentions.
Home Equity Requirements
Before committing any time and energy, you’ll want to know whether or not you even qualify for a home equity loan in the first place.
Different equity lenders will have different requirements, but generally, you’re going to need 10-20% equity in your home to be able to access any loan options.
You can understand your equity by subtracting your mortgage (and any other debts secured by your home) from the current market value of your home, with the remaining amount being your home’s equity.
In addition to having equity, you’re also going to need a credit score of at least 550, although ideally closer to 650, as well as a debt-to-income ratio (DTI) (the percentage of your monthly income that goes to paying your debts) of around 36% or lower.
While you’ll most likely be able to find loan options requiring less than stated above, it’s worth keeping in mind that the higher your credit and DTI, the higher rates you can expect to pay.
Home Equity Options
If you do qualify, the next step is to understand the three main ways to tap your home’s equity:
- Home equity loan: Also called a second mortgage, this option gives you a lump sum to be paid back at a monthly, fixed rate over 5-30 years.
- Home equity line of credit (HELOC): A HELOC allows you to withdraw only as much as you need, when you need, up to a certain amount over a 10-year period. You then simply pay off the interest (or principal) every month at a variable interest rate.
- Cash-out mortgage refinance: Replacing your current mortgage, a cash-out refinance gives you the difference between your remaining mortgage amount and your home’s equity in cash.
It’s important to research each of these options yourself as different options can better benefit different projects, as you’ll read below.
Common Reasons People Use Home Equity
With an understanding of the requirements and your available loan options, the final step to understanding whether or not home equity is the right choice for you is making sure your reason for wanting to use home equity is justifiable.
To help you do that, consider the five most common reasons people opt to use the equity in their homes:
- To add value to your home
- To consolidate debt
- To pay for education
- To start a business
- To create a rainy-day fund
1. To Add Value to Your Home
By far the most common reason to take out a home equity loan is for home improvement, with an emphasis on improving the value of your home.
This is because, in addition to making your home more enjoyable to live in, upgrading your home can work as an investment in the sense that you’re increasing its value, potentially netting you more on the market if and when you do ultimately decide to sell your home.
If this is your goal, then improvement projects centered around kitchens, garage doors, entry areas, and outside additions (decks, patios, pools, etc.) are all smart choices.
Another reason people use home equity for home improvement is that you can deduct interest paid on mortgages up to $750,000 if you use home equity funds to “buy, build or substantially improve the taxpayer’s home that secures the loan,” according to the IRS.
This holds true as long as the funds from your home equity loan are used to renovate the property that you’re borrowing against. If you’re using the funds to renovate a secondary property, you can’t deduct the interest.
Note: Before committing to home improvement through home equity for this interest deduction perk, brush up on the most current rules and updates as they have become more and more stringent in recent years and may be different depending on where you live.
2. Consolidating Debt
After home improvement, consolidating debt is the next most popular reason people take advantage of home equity.
People choose to pay off personal debts, such as a car loan or credit card, with a home equity loan because home equity loans tend to have much lower interest rates and can be paid off over a longer period of time, freeing up more money on a monthly basis.
With these perks, however, come some risks. For example, by converting credit card or car payment debt into a home equity loan, you’re turning unsecured debt, debt not secured by collateral, into secured debt backed by your home. This means that if you’re unable to pay off your loan, you risk losing your home to foreclosure — a much more severe punishment compared to simply accruing more interest on your unpaid credit card bill.
3. Paying for Education
Many people also choose to use home equity loans to pay for education, particularly when mortgage rates are significantly lower than student loan interest rates and term lengths are longer — two factors that result in lower monthly payments.
Paying for education with a home equity loan comes with the same risks as consolidating your debt with a home equity loan; not paying your student loan simply results in poorer credit, whereas not paying your home equity loan can result in losing your home.
And at the risk of sounding cruel, it can also be risky using your home equity loan to pay for something that doesn’t directly affect you as the homeowner and your ability to make payments or your home itself and its value.
While parents naturally want to pay for their children’s education, if that education doesn’t directly increase the value of the homeowner or property itself (here’s to hoping your child becomes a millionaire!), it can add unnecessary stress and risk that aren’t present with regular student loans.
4. Funding a Business
Along the same lines as the point above, using a home equity loan to start or fund a business is a justifiable use of home equity as it (hopefully) increases your means and capability to pay off your loan down the road.
If you need a large amount of funding right off the bat, a regular home equity loan is likely the best choice, as it gives you access to your full amount right away. Home equity loans also have the added benefit of a fixed interest rate, meaning you’ll know exactly what you’ll pay every month for years to come.
However, if you don’t need your entire lump sum, taking out a HELOC might make more sense, as you take out only what you need, when you need it, and pay off the interest and/or principal every month.
5. Creating a Rainy-Day Fund
Finally, many people opt to secure themselves and their families by using a home equity loan as a rainy-day or emergency fund, giving them access to cash should an expensive emergency or sudden loss of means occur.
In most cases, a HELOC makes the most sense as an emergency fund, as you can quickly take out exactly as much cash as you need in the case of an emergency.
It’s worth mentioning, though, that it’s never a good choice to rely solely on a home equity loan as your sole emergency fund; you should also be contributing to other, non-debt-funded emergency funds.
When deciding whether or not a home equity loan is the right choice for you follow these three steps:
Check to see that you qualify for a home equity loan in the first place
Understand the different types of home equity loans available and their respective benefits
Check to see that your intentions are justifiable and that your plans wouldn’t be better served through something other than a home equity loan
And while there are certainly other justifiable reasons to use home equity loans other than those listed above, avoid using a home equity loan for lifestyle purchases (vehicles, vacations, etc.), as well as a bandage to any underlying problem, such as overspending or living outside of your means.