Home equity is the difference between the current market value of your home and the amount of mortgage debt owed on the home. The amount of your home equity typically increases as you pay down the mortgage debt on your home. It’s important to note that home equity can increase or decrease depending upon changes in the home’s market value as well.
Tapping your home’s equity as a source of funds is an alternative to using credit cards or obtaining a personal loan. Credit cards and personal loans are forms of unsecured borrowing. You incur a debt and repay the amount of the debt along with interest. Borrowing against your home’s equity involves a loan or a line of credit against the equity in your home. You also make payments of principal and interest. The interest rate on these loans is often lower than an unsecured loan due to the fact that a home equity loan or a home equity line of credit is secured by your home.
Tapping your home equity
There are no hard and fast rules, but it generally makes sense to tap your home equity for things like home improvements or educational expenses. Home improvements can increase the value of your home. Financing a college education is an investment in yours or your child’s future.
Using home equity to purchase a car or an appliance may not be a good use of this equity as these are assets with a very limited life and do little or nothing to improve your net worth.
Risks of tapping your home equity
The major risk with tapping home equity occurs if your home decreases in value. This can cause you to become upside down on your mortgage, in other words you can end up owing more than the home is worth between the equity line of credit and your first mortgage.
It’s also important to know that most lenders will impose a maximum amount that you can borrow via a HELOC or home equity loan.
Here are five reasons you might consider tapping your home’s equity.
1. Debt consolidation
Using a HELOC or otherwise tapping your home equity via a home equity loan or a cash-out refinancing to consolidate a variety of debts such as auto loans, credit card debt and other types of unsecured debt can have some benefits for homeowners. Here are some pros and cons to consider.
| Pros | Cons |
|---|---|
This can be a good way for homeowners to consolidate a number of smaller loans into one monthly payment. This can often result in lower overall debt payments than by paying each loan or credit card off separately. | |
The interest rate on a home equity loan or line is often lower than those on the individual debts being consolidated. |
2. Education
A home equity loan or HELOC can be a viable alternative to taking our student loans to finance college or graduate school costs. Be sure to check with your lender to be sure that they allow this as a use for the money. Here are some pros and cons to consider.
| Pros | Cons |
|---|---|
| A home equity loan can offer a lower rate than conventional student loans. | Defaulting on a home equity loan can result in foreclosure |
In some home equity loan cases the repayment period can be stretched resulting in lower payments. | |
home equity lines and HELOCs might offer higher borrower limits. | |
Some colleges may consider the net market value of your home in doing their financial aid calculation, using a home equity loan can reduce this net market value and prove beneficial in their aid calculations. |
3. Home improvement
Making home improvements is one of the most common reasons that homeowners choose to tap their home equity via a HELOC or other type of loan. Here are some pros and cons to consider.
| Pros | Cons |
|---|---|
You are using the money to improve the asset against which the loan is secured. | If your home value decreases, you can end up owing more on your home than it is worth. |
Home improvements can increase the liveability of your home | |
Certain home improvements can increase the value of your home |
4. Investing
Your home equity can be a source of funds for conventional investments like stocks, bonds, mutual funds and ETFs. It can also be a source of funds for a private investment like buying or starting a business, investing in a private company or perhaps investing in real estate. Here are some pros and cons to consider.
| Pros | Cons |
|---|---|
Your home equity may be your most readily available source of funds | Investing in the stock market is high-risk |
All investments carry some risk | |
If you lose money on these investments you still owe the full amount of the equity borrowed, plus interest. You could lose your home and/or find yourself upside down on your mortgage. |
Many experts strongly discourage tapping your home to make any type of investment.
5. Unexpected expenses
As the name implies, unexpected expenses are just that, unexpected and unplanned. Examples of unexpected expenses can include:
- Health related issues for yourself or a family member.
- Damage to your home over and above what is covered by homeowners insurance.
- Liability you incur to an accident resulting in property damage or bodily harm.
- A wedding for either yourself or an adult child.
In some cases, your home equity might be the only available source of funds available to you for these types of expenses.
Home equity is a resource available to homeowners and can be useful if utilized properly. If you do decide to tap your home's equity be sure to consider a variety of lenders and loan types.