Rising real estate values mean many homeowners are saddled with equity—the difference between what they owe and what their home is worth. The median home price has increased 42 percent since the pandemic began, and the average homeowner with a mortgage now has more than $207,000 in equity, according to Black Knight Inc.
Spending that wealth can be tempting. Proceeds from home equity loans or lines of credit can help pay for home improvements, college tuition, debt consolidation, new cars, vacations—whatever the borrower needs.
But just because something can be done doesn’t mean it should be done. One danger of this type of loan should be very clear: you are putting your home at risk. If you can’t make the payments, the lender can foreclose and evict you.
Also, as we learned during the Great Recession of 2008-2009, home prices can also fall. Home equity borrowers are more likely to be “underwater” — or owe more on their home — than those without home equity loans or lines of credit, according to a 2011 report by CoreLogic, a. Real estate information company.
Other risks are less obvious but should be considered.
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You may want your equity later
Many Americans are not saving enough for retirement and may need to use their home equity to avoid a significant drop in their standard of living. Some do so by selling their home and downsizing, using cash to invest or otherwise supplement retirement income.
Other retirees may switch to a reverse mortgage. The most common reverse mortgage allows homeowners 62 and older to convert home equity into a lump sum of cash, a series of monthly payments, or a line of credit that they can use as needed. The borrower does not have to repay the loan as long as the borrower lives in the home, but the balance must be paid when the borrower dies, sells or moves out.
watch outThis new type of reverse mortgage can help retirees generate more income.
Another way home equity can be used is to pay for a nursing home or other long-term care facility. A semi-private unit in a nursing home will cost an average of $7,908 per month in 2021, according to Genworth, which provides long-term care insurance. Some people without long-term care insurance plan to borrow against their home equity to pay those bills.
Obviously, the more you owe on your home, the less equity you have available for other uses. In fact, a large mortgage can prevent you from getting a reverse mortgage. To qualify, you must own your home outright or have a significant amount of equity – at least 50% and possibly more.
Read: My husband and I have $750,000 in savings and earn over $144,000 a year. Can we spend $5,000 a month on housing?
You owe a lot
Using your home equity to pay off a lot of debt, such as credit cards, may seem like a smart move. Best of all, home equity loans and lines of credit tend to have very low interest rates.
If you file for bankruptcy, however, your outstanding debts — such as credit cards, personal loans and medical bills — are typically discharged. Debt secured by your home, such as mortgages and home equity loans, is typically not.
Before using home equity to consolidate other debts, consider talking to a nonprofit credit counseling agency and bankruptcy attorney about your options.
ReadHousing market ‘weakening significantly’ from April peak led by Seattle, San Francisco and San Diego
What you buy does not end with the debt.
Borrowing money for pure consumption, like vacations or electronics, is rarely a good idea. Ideally, we should only borrow money for purchases that increase our wealth: a mortgage that will appreciate, for example, or a student loan that will generate a higher lifetime income.
If you’re considering borrowing home equity to pay for something that won’t appreciate in value, at least make sure you’re not making payments long after its useful life is over. If you’re using home equity to buy a vehicle, consider limiting the loan term to five years so you don’t end up with large maintenance bills while still paying off the loan.
Home equity loans usually have fixed interest rates and fixed repayment terms of five to 30 years. A typical home equity line of credit, meanwhile, has variable rates and a 30-year term: a 10-year “drawing” period, during which you can borrow money, followed by a 20-year repayment period. You’re usually only required to pay interest on your loan during the draw, which means your payments can jump significantly at the 10-year mark when you start paying off the principal.
This leads to a final piece of advice: With interest rates on the rise, consider taking out a home loan or line of credit only if you can pay off the balance quickly. If you need a few years to pay back what you owe, getting a fixed rate home equity loan may be the best way to tap into equity now.
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Liz Weston, CFP® writes for Nerd Wallet. Email: email@example.com Twitter: @lizweston.