A good financial adviser would always advise a home owner to avoid tapping home equity whenever possible. This is mainly because home equity loans and home equity lines of credit mean that you will be putting up your house as collateral against the amount you borrow. This means that if you get into some unforeseen financial trouble and cannot keep up with the payments, you could risk foreclosure of your home. Furthermore, the fees and interest rates associated with this type of loan can be astronomical.
However, there are a few instances where this practice can be beneficial. For example, if you take out a home equity loan to pay for home improvements (such as renovating your kitchen, for example), this can prove to be profitable because it can raise the value of your home.
Before you begin, you should take time to understand the options available. There are two types of home equity borrowing:
- home equity loans
- home equity lines of credit
Home Equity Loan
A home equity loan is like any other type of loan, and means borrowing a fixed amount that must be paid out over time with interest. The interest rates are generally fixed and you pay the same amount each month.
Home Equity Line of Credit
A home equity line of credit, means freeing up a portion of your equity to be borrowed against whenever you like. Generally, lines of credit have variable interest rates based on the current prime. According to the Consumer Bankers Association, the average home equity line of credit in 2004 was $77,526, while the average home equity loan was $62,112.
Some Tips for Tapping into Home Equity
Once you have decided that you need a home equity loan or a line of credit, consider the following tips for tapping home equity:
Avoid Fees:
Many lenders ask for fees associated with home equity loans or lines of credit. They assume that consumers will simply accept the fees as part of the loan process. However, if you bring the fees to their attention and insist that the fees be waived, it is highly possible that you will end up getting your way. This is especially true if you have good credit and a positive payment history.
Compare Rates:
Any time you pursue this big of a financial decision you need to compare the rates of multiple lenders. If the interest rates are several points above prime and you have a good credit score (700 or above), you probably need to go elsewhere. Even a credit score in the high 600s should only warrant an interest rate a point or so above prime. Talk to several lenders and try to negotiate as far down as possible.
Fix the Problem. If you are considering a home equity loan or line of credit to suit short-term financial needs, you need to examine the reason behind your monetary deficiency. Most people fail to follow a budget and they find themselves relying on credit much more often than advised by financial professionals. Getting to the source of the problem - such as compulsive overspending - will help you to manage your money more efficiently and avoid borrowing against your home in the future.
Consult Your CPA:
The tax requirements will vary on your home equity loan or line of credit depending on your lender and other factors, such as the interest rate and the prime level. Before you apply for a loan or line of credit, talk to your CPA and make sure you understand the tax requirements. In some cases, your interest will be deductible up to $100,000 of credit, but you will probably have to itemize in order to qualify.
Leave a Cushion:
Regardless of your financial need, it is never a good idea to leave less than 20% equity in your home at all times. That way, if something goes wrong or an emergency arises, you still have a source of funds. This will also keep the tax implications and interest rates to a minimum.
Know the Risks:
Many home owners are so anxious to get their hands on the money from a home equity loan or line of credit that they don't consider the future of their finances. If you drain the equity out of your home, your "rainy day fund" goes out the window and you’re left with even more money to pay back. Unless the loan or line of credit is a significantly beneficial option, you might want to consider alternate avenues to come up with the cash you need.