As you pay off your home loan, you’ll build equity in your home. Equity is the value of your home that’s considered to be debt-free, or already paid for, and it can be used as collateral against a loan if you need it.
A home equity loan is one way to use the equity you’ve worked hard to build up to meet pressing financial needs.
When A Home Equity Loan Makes Sense
A home equity loan can be a great way to handle sudden expenses and meet other financial needs, but it needs to be used wisely. After all, you’re putting your home on the line when you borrow against the equity you’ve built up.
Some situations when a home equity loan is a good idea include:
Covering emergency expenses
Sometimes, you get hit with sudden expenses. A massive hospital bill, a death in the family, or other sudden financial and emotional shocks can be difficult to overcome without sufficient funds. A home equity loan can help you meet those expenses without incurring high-interest credit card debt or borrowing from a retirement fund.
One common use of a home equity loan is to consolidate high-interest debt. If you have multiple loans and debts with high amounts of interest, you can use the funds from your home equity loan to pay those off, effectively replacing them with a single monthly payment.
The interest rates on home equity loans tend to be lower than those on other types of loans, and they’re far lower than most credit card rates. As such, you’ll not only simplify your debt, but also reduce the amount of interest you’ll have to pay. That means you’ll have lower monthly payments and less interest to pay long-term, potentially saving you thousands once it’s paid off.
Making home improvements
Another valid use for a home equity loan is to fund home improvements. These improvements can add value to your home, creating a return on your investment, and they can even possibly help you save on your taxes (consult your tax advisor).
For example, if you’re planning improvements to your home that would make it more energy-efficient, you might qualify for tax credits designed to reward homeowners for making such improvements. On top of saving energy, you may have a lower tax bill as well.
The interest from these loans may be tax-deductible, potentially reducing the amount of taxable income you have to report.
Of course, one caveat here is to make sure you keep your home within the general limits of your neighborhood and make improvements that would provide a return. Real estate agents often base a home’s sale price on the going rate in the area, which may mean you won’t be able to get any return on your investment.
Ensure the improvements you make provide a greater benefit than the cost of the loan and interest.
Paying for other investments
Other costs may warrant a home equity loan, such as paying for college tuition. The idea is to make sure the loan is used for improving your future, so any investment you might make that would yield long-term benefits could be worth funding with a home equity loan.
When To Avoid A Home Equity Loan
While your home’s equity can be used for good purposes, it’s important to use it only when it would be worth the risks. Remember that the loan is backed by your home’s equity, so if you default on payments, you might face foreclosure. In addition, the approval process is more involved than other loans, and you’ll have to pay closing costs as well.
With that in mind, some scenarios where you’ll want to avoid a home equity loan include the following:
Some large purchases don’t warrant a home equity loan. Going on expensive vacations, funding a large wedding, purchasing recreational vehicles, and so forth aren’t strictly necessary, and although they’ll provide some short-term enjoyment, they don’t actually translate into long-term improvement for your future.
Put simply, some purchases are pressing enough to warrant an equity loan, but others are worth saving up for the hard way.
Shaky financial situation
If your financial situation isn’t stable, then it’s not recommended to consider a home equity loan. Even though it can be used to stabilize your situation if you have a lot of high-interest debt, it will still constitute a form of debt itself, so you’ll need to make sure you can handle the monthly payments on it.
If your credit isn’t the best, consider trying to make improvements before using a home equity loan. Doing so will get you a lower interest rate and make it easier to get approved.
Identify If A Home Equity Loan Is Right For You
To see if a home equity loan is wise for you, consider these questions:
- How much equity have you built up in your home already?
- What is your purpose? Are you consolidating debt? Funding improvements?
- What benefits will you get as a result of borrowing against your home?
- Is the purchase you want to make necessary? Can it wait?
- Do you have good credit?
- Can you make the monthly payments?
If you plan to use your loan to benefit your future or to handle emergency expenses that you can’t afford otherwise, then a home equity loan may be right for you. Even so, talking to a lender will be necessary to make sure and to get the process started.