Tapping your home equity can seem like a smart move. Whether you want to pay off credit cards, cover a child’s college tuition or remodel your house, home equity seems like a relatively cheap source of money.
But you’re putting your home at risk if you can’t make the payments. Plus, if you consistently spend more than you make, you could be squandering an important source of wealth only to end up further in debt down the road. Here are questions to ask before you borrow against your home.
Is this a Band-Aid on a bullet hole?
If you’re paying off other debt, have you fixed the problems that caused you to overspend? If you’re proposing new spending, are you trying to pay for something you can’t really afford? Before you borrow against your home, make sure you’re living within your means and not setting yourself up for more debt.
How much value will this really add?
The vast majority of home improvements don’t increase the value of your home enough to cover their cost. Borrowing only a portion of the expense (say, 50%) and paying for the rest out of savings is often a better approach. Using home equity to pay for your own education or to fund a business can make sense if your income will rise as a result (but of course that won’t pay off if you don’t get the degree or the business fails). Paying for a child’s education should result in higher income for her, but it won’t increase your own.
How high could my payments go?
There are 3 ways to tap your home’s equity:
- A home equity line of credit, or HELOC.
- A home equity loan.
- A cash-out mortgage refinance.
Lines of credit typically have variable rates that start low but can climb over time. Home equity loans typically have fixed rates and 5-year to 15-year payback periods, while cash-out refinances can have variable, fixed or hybrid rates (fixed followed by variable) and typically terms of 15 or 30 years. Figure out the worst-case scenario payment so you understand how much you might be expected to pay.
How long will it take to pay off the debt?
If you can pay off what you owe in 5 years or less, then a home equity line of credit may be your best bet because HELOCs are relatively cheap to set up. If paying back your debt will take you longer than 5 years, you’ll probably want the safety of fixed rates and payments. Home equity loans typically offer 5-year to 15-year payback periods.
You can get even longer payback periods and lower rates with a cash-out refinance, but refinances come with closing costs that can total hundreds or thousands of dollars, plus they change the rate on your primary mortgage.
What are my other options?
You should identify and investigate as many as possible. A list to get you started:
- Other sources of cash. Before you borrow, think about resources you already have that you could tap. Do you have savings, stuff you can sell or non-retirement investments you could liquidate? If so, using those resources often makes more sense than adding debt.
- Other sources of credit. Credit unions and marketplace lenders offer personal loans with fixed rates and payments. The federal government and private lenders offer education loans for students and parents. Family or friends may be willing to lend you money. Check out Bankrate.com’s personal loan offerings.
- Borrowing from yourself. You may be able to take out loans against your life insurance or retirement accounts. Research these options thoroughly, since you’re putting these sources of wealth at risk if you can’t make the payments.
- Not borrowing at all. Vacations, weddings, luxuries and consumer goods should be paid out of current income and savings. Most spending, in fact, simply isn’t important enough to justify borrowing against your home.
After answering these questions, are you ready to shop for a home equity loan or HELOC? Compare lenders on Bankrate.com.