Home Equity and Investments
Once you own a home for a while, you build more and more equity. Of course, this means that more and more of the home's total value is yours to keep — it does not belong to the bank anymore. One of the ways you can borrow throughout your lifetime is to use your home's equity as collateral. As with all loans, this can be a wise move, or a surefire way to damage your credit.
Big Loans, Little Rates
Home-equity loans are often used for large loans. Why? Your home is likely one of the most valuable assets you own. Furthermore, you may have much of your net worth tied up in your home's equity. After years of making mortgage payments, and enjoying some price appreciation if you are lucky, you may end up with a huge resource.
Because you have good equity in your home, you can take big loans off it. To sweeten the deal, your interest rate is likely to be lower than other interest rates you might find in the marketplace. For example, if you have the choice of borrowing on a home-equity loan versus a credit card, the home-equity loan should have a lower rate. Lenders offer you a slightly better rate because the loan is secured by your house. If you don't pay it back, you might lose your house. Lenders figure that you will make repayment on a home-equity loan a priority above other unsecured loans if you fall on hard times.
Banks do not like foreclosure — when they take your house — any more than you do. They're in the business of lending money, not selling houses. It costs them money and resources to do a foreclosure. Therefore, you can often work something out with them if you are proactive and sincere about saving your home.
Smart Home-Equity Loans
You can use a home-equity loan for a lot of different things, but if you want to improve and protect your personal financial situation, you should probably limit yourself to a few areas. In general, a home-equity loan might be a good idea if you will use the loan proceeds for some kind of investment.
One example of an investment you might make is an investment in your home. If you want to spruce the place up and make some improvements, a home-equity loan seems reasonable. You borrow money from the house, but you increase the value of the house with the loan proceeds. If done right, you can more than repay the loan when you sell. Common examples of home improvements might be:
Adding or updating a bathroom
Remodeling the kitchen
Adding rooms or levels to the home
Purchasing a second home or investment property
Another use for your home-equity loan might be an investment in your child's education. Borrowing for education is discussed later in this chapter.
Investment in the Future
When you are building up home equity, you are giving yourself more options in the future. You will have a large pool of resources that you can draw upon if the need ever arises. As you grow older, you may find that you want to just take that money back out and live off it. This is possible with the use of a reverse mortgage. Instead of making payments that build equity, you receive payments that reduce equity. You are borrowing back your own money.
Reverse mortgages are complex, and you should spend a lot of time researching how they work before you even think of pulling the trigger. However, they are worth the research for many. They offer a way to get income if there are no other options, and they have some built-in features that allow for flexibility and limit your family's risk. A reverse mortgage will never be a possibility if you don't take the steps to own a home and build equity.
Home-Equity Tax Breaks
When you borrow against your home, you may be able to take a tax deduction on the interest you pay for the loan. This lowers the effective cost of the loan: you pay interest, but you get a break on your taxes later. Keep in mind that there are limits to how the tax deduction is applied. You might want to have your tax advisor calculate the deduction, or you can view the details in IRS Publication 936.
You can lower your total costs of borrowing by deducting the interest you pay on a home-equity loan. However, the deduction is not unlimited, and there are restrictions that apply to the source of equity and the use of funds. Before you claim a deduction, be sure you are entitled to it.
Home-Equity Loan Pitfalls
Home-equity loans can be very tempting: big loan, small rate, and potential for a tax break. Nevertheless, you need to proceed with extreme caution. The main risk is that you put your home on the line. If you cannot repay the loan as agreed, your home is the collateral that banks will seize. Before taking that risk, decide whether it is worth it to you.
Plenty of people use home-equity loans for debt consolidation. While this certainly works, they sometimes put themselves in a worse situation. Home-equity loans should only be used for debt consolidation when you have a formal plan for debt reduction, and the ability to execute it.
Finally, be on the lookout for scam artists. Home-equity loans have been a notorious area of abuse in the past. When you have a large-ticket loan, unscrupulous people get tempted to take advantage of a situation. In fact, predatory lenders target people with bad credit because they figure that people with bad credit are less sophisticated. In general, they tend to fleece people into agreements they don't understand, they charge high fees or unnecessary fees, and they find ways to repeat the charges over and over. If you have any doubts about a lender, ask your friends, family, and acquaintances you trust.
