As a homeowner, you might be considering using the value in your home to help achieve your financial goals. One option for tapping into the value of your house is a home equity loan or line of credit.
A home equity loan or line of credit, also known as a second mortgage, allows homeowners to borrow money by using their home’s equity as collateral.
What Is a Home Equity Loan?
When you have home equity, you owe less on the home’s mortgage than the home is worth. With a home equity loan or line of credit, you borrow against this extra value or equity to take out a loan. Your home is collateral for the loan. That means that if you’re unable to pay the loan, you can lose your home to the bank.
There are two types of home equity loans: fixed rate and variable rate. With fixed rate loans, you’ll take out a single lump sum, and you’ll repay the sum over a set period of time with a fixed interest rate.
Home equity lines of credit are variable rate loans. Borrowers are pre-approved to borrow up to a certain amount of money for the life of a loan (often 5 or 10 years). During the time limit of the loan, you can withdraw money as you need it. When you pay off the principal, you can withdraw and use the credit again if needed.
The interest rate will vary depending on the bank’s interest rate, and the payment will vary depending on the interest rate and the amount of credit used.
During the recession, home equity loans decreased in use as many borrowers had little equity in their homes. But with improving home prices, home equity loans have been increasing steadily in use since 2010. Experian’s recent study on home equity loans found that originations are up 81% to $37 billion in Q4 of 2014 as compared to $20.44 billion in Q4 of 2010.
But what can a home equity loan do for you, and is using one a wise financial move?
How You Can Use a Home Equity Loan
Home equity loans can be a valuable tool for responsible borrowers. Like most forms of debt, it can be a tool to leverage your financial situation — but it’s a tool that can be used responsibly or foolishly. Here are three scenarios where it might make sense to use this type of loan:
Pay off credit card debt: If you have large amounts of credit card debt, taking out a home equity loan might be one way to get on top of the debt. It’s hard to make progress if you are paying a double digit interest rate on a card, and home-equity loans often have a much lower interest rate. By refinancing the credit card debt onto a home equity loan, you can put the amount you were paying in interest towards paying down the debt.
But if you are considering this, be careful. You must reduce your expenses and change your spending habits for the better. If not, you’ll continue to rack up credit card debt, and you’ll have put your house at risk only to owe more. If you aren’t actively working on a debt repayment plan, it’s too big of a risk.
Pay for your child’s college education: Many parents hope to pay for their children’s college education. Sometimes, parents are able to get a better rate on a home equity loans than on federal, parent PLUS loans.
If you are considering this, make sure to look at how the home equity loan will impact your retirement goals. If you plan to use a home equity loan, you’ll need to factor this loan into your retirement savings target. In many cases, this additional payment is manageable, and parents are able to meet their retirement goals without a large delay.
In case of an emergency: Home equity lines of credit are an excellent way to tap into some additional cash if needed for extreme emergencies. You’ll want to have cash for small emergencies in a savings account regardless; a loan can serve as second line of defense. Since many home equity lines of credit cost very little to have open every year, it’s a small cost to have the access to large amounts of cash when needed in true emergencies.
A Home Equity Loan Isn’t a Cure-All
This type of financial product is just one tool that you could potentially use in your financial toolbox. If you’re considering opening to a home equity loan, know that you’ll need to incorporate your action into a larger strategy to stay on track to meet your financial goals.