Home equity loans are secure loans, which means you are putting your home up for collateral against the money you borrow. They tend to offer fairly low interest rates and allow for a tax deduction. There are two main types of equity loans. There is the standard home equity loan where you typically receive a lump sum which you repay on a monthly basis. Terms can range from 5-15 years, or potentially up to thirty depending on the lender. Another type is a HELOC (Home Equity Line of Credit). With a HELOC, you are given a predetermined amount that you can borrow against as you wish. You only pay interest on what you borrow and repayment doesn’t begin until a period of time known as the draw (e.g. – 10 years) has elapsed.
Essentially, home equity loans are a second mortgage, with the original purpose of home improvement projects to improve equity. But it can be tempting to tap into that wealth and use it for other purposes. Here is a short list of Do’s and Don’ts:
- DO NOT fund a lifestyle or use as supplemental income – it is not wise to squander your equity. Sure boats and sports cars and lavish lifestyles are nice, but only if you truly can afford them. Should property values crash, you could lose your home! In addition, if your income is unstable or could take a turn for the worse in the foreseeable future, these may not be good options for you. If you are unable to keep up with your payments, lenders may force you out!
- DO put the money back into your home – home repairs or upgrades, especially equity building projects, that will add to your home’s value are the origination of these loans and the smartest thing to use the money for. Invest in your investment!
- DO NOT pay bills or everyday expenses – groceries, utilities, and monthly bills should already be factored into your household budget. If you are having a hard time paying for your regular expenses, it may be time to re analyze your budget and make cuts where necessary. Remember, if you can’t repay your loans you could lose your house!
- DO consolidate debt – although this can be tricky if you lack in the discipline department. Yes, saving thousands of dollars on interest charges is a wise investment. It can also be tempting to run those balances back up afterwards, leaving you in more debt than you started. Proceed with caution!
- DO NOT tap into home equity if you plan on selling soon – all debts on a house must be settled before it can be sold. Don’t plan a major renovation you can not afford to pay off before settlement.
- DO consider purchasing income-producing property – invest home equity into rental property or a sound investment that will have a higher return than the loan itself (e.g. – property “flipping”). Just be sure to analyze your finances carefully. Again, proceed with caution.
- DO NOT take more than necessary – you could be stacking the risk of failure to repay and you will be paying more interest. If you aren’t sure how much you will need to borrow, talk to a financial advisor about the HELOC option, but still, only take what you need! This will also keep you from spending unused cash on unnecessary luxuries.
- DO shop around and consider a variety of options – visit several lenders to find the best loan you qualify for. Seek out the best loan terms available and compare the APR of loans from different lenders. The APR takes into account both the interest rate and the points and fees of the loan. Ask for written estimates that include all points and fees.
Home equity loans and lines of credit can be a valuable choice for many, but certainly not for all. Ask lots of questions. Always remember, if you are not sure then don’t sign!