Financial Advisor Insights

Should You Use Your Home’s Equity?

Updated for 2018. A home equity loan and a home equity line of credit (HELOC) provide access to a home’s equity. Although similar, a home equity loan is not the same as a line of credit. A home equity loan is essentially a second mortgage to provide cash that can be used for any purpose. Similar to a regular mortgage, a home equity loan will have a one-time equity draw, typically a fixed interest rate, and monthly repayments. 

Should you tap your home's equity?A home equity line of credit is often compared to a credit card, as you may access all or portions of your equity line during the draw period, but aren’t required to take out the entire amount. The structures of HELOCs vary by institution and current economic conditions. Typically, a home equity line of credit will have a draw period where you may access funds, followed by a repayment period. Interest rates will vary but are typically variable and some may have a balloon payment. 

How much home equity can you use? 

A home equity loan or a line of credit can be obtained from mortgage firms, credit unions, banks, as well as other loan and savings organizations. Home equity loans and HELOCs typically lend up to about 75 to 80 percent of the property’s combined loan-to-value ratio (CLTV). Here’s an example:

Appraised value of property: $350,000

Current mortgage loan balance: $250,000

Equity desired: $30,000

Combined loan amount: $280,000

CLTV = 80% (loan balance + equity desired) / appraised value 

As with a regular mortgage, keep in mind that just because a bank is willing to lend it to you, doesn’t mean you can afford it. Be mindful of your budget, other financial goals, and income expectations for the future. 

Home equity loan or HELOC? New Call-to-action

A home equity loan may make sense for a borrower with specific financial needs in a short timeframe, without the need to draw additional funds later. A risk of the loan is tapping more equity than needed and either spending it on lifestyle expenses or incurring a prepayment penalty for an early repayment. 

A HELOC may be more appropriate for someone who has staggered financial needs with undetermined amounts. While some may be disciplined enough to only use what they need, others may fall into the same traps as borrowers with severe credit card debt. HELOCs may have some features in common with credit cards, but they are not the same; with a HELOC you are literally putting your home on the line. 

Best uses for a home equity loan or HELOC 

There isn’t a black and white answer as everyone will have different reasons for using their home’s equity. In general, it isn’t advisable to tap your home’s equity for a life event like a wedding, lifestyle expenses, college, or paying down debt. If you are trying to navigate interest rates and using home equity looks more attractive, consider refinancing or increasing your monthly principal payments. While paying for college is a burden on most families, the availability of scholarships, financial aid, and student loans should always be considered before putting your home at risk. 

Accessing your home equity usually makes the most sense when it is used for upgrades or repairs on your home that will increase its value. Another common way to use home equity is when buyers wish to buy a new home before selling their old one. Consider discussing with a real estate professional beforehand to better understand the current market and a possible sale price once the renovations are complete. Living through a renovation can be tough, so ensure the risk is worth the reward. 

It can also make sense to draw from your home equity if you only need a relatively small portion or have paid off the residence entirely. Under the tax reform bill signed in December 2017, interest on a home equity loan or line of credit is no longer be tax-deductible if not used for "acquisition indebtedness", beginning in the 2018 tax year. There is no "grandfathering" of loans taken out prior to January 1, 2018. 

Know the terms 

Whether you decide on a HELOC or a loan, be sure to fully understand the terms of the arrangement.

  • Rates: Low introductory or teaser rates can surprise homeowners when their payments increase. If you have a variable rate, is there a cap?

  • Repayment: Understand how you pay back the loan. Are there prepayment penalties or balloon payments? If you are planning to sell the home soon, the full note will likely become due at that time.

  • HELOC terms: HELOCs are more complex instruments; some may have a provision for requiring mandatory withdrawals or a penalty closing the equity loan early. 

Having equity in your home is a big benefit of homeownership. Making the decision about whether or not to tap your home’s equity will depend on a number of factors, but for many it will come down to the availability of alternatives and the relative proportion of equity being borrowed. Keep in mind the volatility of the real estate market before making your decision; markets fluctuate and neighborhoods change, so you may not know what could affect your appraisal. 
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