Using the Equity in Your Home Wisely

You’ve paid down a significant amount of your mortgage. Since you have, you now have an equally significant amount of home equity.

This is good news. Home equity provides you with a measure of financial freedom. You can borrow against this equity to help pay for your children’s college education, fund a major kitchen remodel or pay off your high-interest rate credit cards.

It is possible, though, to mis-use your home equity. Remember, home equity loans, or lines of credit use your home as collateral. This means that if you miss payments on a home equity loan or home equity line of credit, your lender could take your home from you.

Fortunately, using home equity wisely just takes a bit of good financial sense.

Using your home equity

You have two choices when you want to borrow against your home’s equity. You can either take out a home equity loan or a home equity line of credit.

With a home equity loan, you receive a lump sum payment for whatever amount you borrow, based on the amount of equity you have available in your home. You then pay back the money you borrow, usually at a fixed interest rate, each month, much like you do with your first mortgage.

A home equity line of credit works more like a credit card. Your existing home equity determines the size of the line of credit available to you. You can then borrow up to that maximum line of credit as often as you like. You do, though, have to pay back the amount of money you borrowed, with interest. If you have a home equity line of credit of $100,000, and you borrow $10,000 to pay for a bathroom renovation, you’ll have to pay back that $10,000 in monthly installments. You’ll still be able, though, to borrow up to $90,000 more before maxing out your credit.

Being smart

Of course, some uses of home equity are better than others.

For instance, if you take out a home equity loan or home equity line of credit, it is usually smart to use the funds to pay for a major home improvement project. That is because if you improve your home, you’ll also be increasing its value. This, in turn, boosts the amount of equity you have in your residence.

Be sure, though, to invest in a home-improvement project that boosts your home’s value. Kitchen updates, the addition of bathrooms and the addition of master bedrooms usually add to the value of a home. Certain cosmetic changes such as new carpeting or landscaping might not.

It might also make good financial sense to use a home equity loan or line of credit to pay off your credit card debt. That is because the interest rates attached to home equity loans or lines or credit are usually far lower than are the ones that come with credit cards. It is better to pay back a $50,000 home equity loan with a rate of 6 percent than credit card debt with a rate of 17 percent, a figure not overly high for standard credit cards.

Again, though, caution is in order: If you do use your home equity to pay off your credit card debt, don’t run up even more credit card debt in the future. You’ll need to change your spending habits to make this move truly pay off in the long run.

It might also make sense to use your home equity to make an investment that will pay off for you in the long term. For instance, some homeowners might tap their home’s equity to invest in rental property that will both generate monthly rental income and, hopefully, grow in value over the years.

Be careful

There are potential drawbacks with borrowing against your home equity. The most serious is the threat of losing your home.

If you miss your credit card payments, you’ll be saddled with an often excessive penalty and a hike in your interest rate. However, if you cannot make your payments on a home equity line of credit or loan, your lender could take your home. So only borrow against your home equity if you are certain that you’ll be able to pay back the loan on time.