Home Equity: Leverage or Let Lie?
What, why, and how to use your line of home equity.
Your investment is a beauty: five bedrooms, granite counters, cathedral ceilings, and hardwood floors. In fact, it’s so good-looking you could probably get a sweet line of home equity on your new home. But just because the possibility of money is out there doesn’t mean you should use it.
What: Home equity is the difference between the fair market value of your house and the unpaid balance of your mortgage. Equity goes up as you continue to pay off your mortgage or as your house appreciates in value. Homeowners can draw a line of credit or leverage their home equity, which is like a loan. “You are actually selling equity in your home when you use a line of credit,” says Ruth Hayden, a CFP in St. Paul, Minnesota. It’s also interest deductible up to $100,000 and you don’t need to qualify what it’s spent on. Sounds like a credit card? It sure does, and you can get into just as much trouble with it.
Why: Use a line of home equity sparingly, not for discretionary spending (plasma TV, new washer and dryer, a trip to Anguilla). “Only draw if the money will be used to increase the long term value of your home,” says Hayden. Maintenance projects like a new roof, new paint, or fixing a sidewalk don’t count. To use the money wisely it should be earmarked for a project that adds value to your home in any market like an addition or renovating a bathroom or kitchen. “It has to be used for a necessity – a capital improvement - not just something you want,” says Carol Buchman, a CFP and CPA in New York City. If you can’t pay for new hardwood floors from your usual cash flow then pick up a sander and do it yourself.
One caveat – and only for extreme situations – is if you have monster credit card debt. “If the interest you have to pay on the line of home equity would be less than what the credit card is charging, and you’ve tried to negotiate with them to no avail, it’s possible to consider using the equity to pay it down,” says Buchman. But be careful not to just create a revolving door of debt – really look at the numbers.
How: So now that you’ve ditched the idea of buying a new hot tub and you have a true need for home equity, when to get a line of credit depends on interest rates, and they always fluctuate. Buchman suggests you first negotiate with contractors and pick someone for the job. Once you know what it’s going to cost, shop around at banks and check out Lendingtree.com for the best rates. Aside from an equity line of credit, you can refinance your mortgage, which means paying closing costs again and taking out cash. You can also get a flat second mortgage, for which you make monthly payments. In general, a line of credit is the most cost effective way of tapping into your home equity.