When Should You Take Out a Home Equity Loan vs. Other Loans?
There's an obvious appeal to home equity loans for financing a big purchase.
You can fund anything from kitchen makeovers to new cars to a tropical vacation.
One of the best ways to decide if a home equity loan is the right means of funds for you, is to take a look at the pros and cons.
Luckily here at MyBankTracker, we've done the hard part for you.
We analyzed home equity loans pros and cons, across five different popular uses for these products.
In this article, we dive in to help you better understand how these tax-favored, take-cash-out-of-your-house solutions work, and whether they’re the right choice for your particular financial need.
But first, let’s take a quick look at the mechanics of these loans.
The Basics of Home Equity Loans
The “equity” part in home equity is the difference between your home's fair market value and the outstanding balance of what you owe on your home.
A simple example is when your home is worth $200,000 and you owe $150,000, then you have $50,000 in equity.
Typically, lenders prefer that you have at least 20 percent home equity, so $50,000 (25 percent) would more than qualify.
Essentially, there are two kinds of home equity products:
- The home equity loan, and
- The home equity line of credit, or HELOC
With a home equity loan, you get your money in one lump sum that you have to pay back with interest.
With a home equity line of credit, you draw down your money over a period of time as you need it.
During the draw period, you pay only the interest on only the amount of money you actually use, as you would with a credit card. During the repayment period, you pay both interest and principal.
Both products are “second mortgages” (the mortgage you took out to buy your house would be the first). The interest you pay on either loan is tax deductible.
Now the five scenarios -- the home equity loan pros and cons:
1. Home Improvement
When you think of taking out either a home equity loan or line of credit, home improvement is the most popular use for the money.
It’s easy to see why.
A house, by definition, is an ongoing home improvement project (money pit).
Popular home improvement projects include kitchen remodels, bathroom additions, new siding, wood decks, window treatments, and attic and basement remodels.
The obvious upside of investing in any home improvement project is you’re increasing the value of your home and enhancing your enjoyment while you continue to live in your home.
Also, the money you’re using to finance these improvements is a cheap source of financing compared to financing the project with your credit card or borrowing from a high-paying investment you don’t want to disturb.
Because repayment periods extend 10 or 15 years, you could always pay off the remaining balance of your note when you go to sell.
Unless you pay off your loan or line of credit before selling, you’re really mortgaging part of your future.
Having tapped part of your equity earlier rather than later, you’ve reduced the size of your asset or retirement nest egg and increased your liability, meaning you might still be paying off that mortgage in your retirement years.
That new kitchen you’re now enjoying comes with the expense of paying two mortgages, not one. In essence, everything you prepare in your kitchen, from eggs to pot roast, carries a surcharge.
Winning decision: Take out the home equity loan
Use your home improvement loan to address much-needed repairs or hazardous situations before they become unfixable or require major renovations, costing you thousands instead of hundreds.
Not all repairs have to be urgent, either.
If your kitchen or your bathroom is such a wreck that it keeps you from inviting relatives or friends over, then it's time to take action.
Your home is your nest so you should be proud to maintain it and occasionally show it off.
2. Auto Purchase
The beauty of using a home equity loan to purchase a car, versus financing the purchase with an auto loan, is that only the home equity loan is tax deductible -- which of course, saves you money.
Consider this example:
Home equity loan taxes
|Auto Loan||Home Equity Loan|
|Annual Interest Charged||$525||$525|
|Marginal Tax Rate||Not applicable||25%*|
|Benefit of Tax Deduction||$0||$131|
|Net Annual Cost of Borrowing||$525||$394|
*Assumes a 25 percent marginal tax rate and the same repayment period for both types of loans. Also, assumes that there are no fees charged for either loan.
So, financing your auto with your home equity saves you $131 annually. What’s not to like?
Car loans run for five years on average. Your home equity loan could last for 15 years.
That’s a long time to be paying for a car (imagine still paying for a car when it’s wheels are about to fall off?).
When you stop making car payments, you only risk seeing your car repossessed.
If you stop making your home equity payments, you risk seeing your home repossessed.
Winning decision: Take out the home equity loan
If you can get your home equity loan at today's great rates, take it.
Just don't string it out for 10 or 15 years.
Restrict your term to five years. This way you'll have more money down the line to rev up savings.
3. Debt Consolidation
Failing to pay the full balance on all your credit cards each month will more than nickel and dime you to death with their high-interest rate charges.
So, tapping your home equity is a great way to corral all those debts and pay them all off at once, in exchange for one monthly payment at a lower rate.
Additionally, if you run the numbers, this consolidation tactic will save you money.
To see how much you would need to borrow for debt consolidation, try the mortgage calculator.
We get the fact that you want to use your home equity to consolidate and pay off your debts at a lower rate, especially if you accumulated that debt after a serious illness or a job loss.
However, if you’re using your home equity to pay off routine bills accumulated because of reckless or irresponsible spending (or that you’re just a bad budgeter), you’re a fool.
Chances are, and statistics show, that getting out of debt isn’t about getting a lower interest rate to finance your debt -- it’s about drastically changing your habits and behavior, which led you into debt in the first place.
Also, keep in mind, if you don't pay credit card bills, though you’ll have a lousy FICO score, you will still have your home.
If you can't make your home equity repayments, your home is at risk.
Winning decision: Skip the home equity loan
Habits are difficult to change, that's why there are millions of new diet and self-help books each year.
It's one thing to read about self-discipline, it's quite another to impose it on yourself.
Sure the numbers pencil out, and make eminent good sense, but betting you'll change your behavior is too risky a proposition when it means you could lose your house.
4. Paying Tuition
Regardless of the one-off stories you hear about Steve Jobs or Bill Gates dropping out of college to start a tech revolution, investing in college is still the best way to get ahead.
So, it’s admirable that you want to use your home equity to reduce your child’s tuition bills.
Clearly, you’ll be giving your son a daughter a head start in life if you’re not saddling them with ridiculous amounts of student loans to pay off over their lifetime.
And again, you should be able to get your hands on home equity cash for a better rate than what either the government or private lenders are charging for student loans.
If you have college-age children, you’re probably no longer the youngest parent on your block.
That means, you should be thinking as much about your retirement as your children’s education.
By taking on another mortgage, you’ll have less money to fund your retirement.
Furthermore, if you tap money now for education, you will have less equity to fund a reverse mortgage later in life.
Also, should you lose your job, it could be a challenge to obtain a new job, and if you do obtain another job -- will it be at the same salary you once commanded?
Furthermore, survey after survey show that many retirees left the workforce before they were ready, and a portion of those blamed their early exit on medical problems.
Maybe you should ask your university-bound student to consider city college for the first two years.
Winning decision: Skip the home equity loan
What kind of lesson are you teaching your children if the message you're sending is to mortgage your house so that some day you might get a good job?
Today, there are too many other educational alternatives, such as massive online open courses (MOOCs), that can help educate a new generation.
Ideally, you would have started an educational fund earlier, maybe when the kids were still in preschool, but you can't beat yourself up for not being a super-parent.
In the last 15 years, the economy has gone through two severe recessions (the dot.com bust and the mortgage meltdown). Some might say you're lucky to even have a roof over your head.
To go into hock to try to address a problem that can be solved by other creative alternatives is not a good use of your equity.
5. Business Start-Up
Few people get rich working for other people, and there’s nothing quite as exciting or personally rewarding as being your own boss.
If you can start a business with cheap capital and produce profits that can easily cover your monthly interest and principal payments, then you’re truly in business.
Consider this example:
Let's say you own a home valued at $200,000, with $80,000 in total debt outstanding and $120,000 in equity.
If you were to borrow $50,000 at 7 percent interest only, your monthly payments would be about $300 (about $3,500 annually in interest expense).
Meanwhile, if your business produced pre-tax profits of about $5,000 per month, you could easily cover the $300 interest.
Moreover, you would have an additional $2,000 for principal reduction. At this pace, you could pay off your entire loan in about two years.
That’s smart use of your home equity.
Business isn’t for amateurs, and if you’re staking your house as collateral for your loan, then you really better know what you’re doing.
The key is:
Keep your monthly debt at a serviceable level.
It’s a challenge guys with MBAs can’t always get right.
If you’re putting your house on the line because you think you can cook better than Bobby Flay, take pause.
Split decision: Take out the home equity loan, but invoke a limit
Life is all about taking chances.
If you're smart, you'll convert these chances into calculated risks.
If people keep telling you your entire life that you're a brilliant photographer or a fabulous cake decorator, then you should buy the equipment or rent the space you need to take your skill to that next level.
Too many business neophytes, however, think they need everything to be perfect to start (business cards, ads in both print and digital media, etc.). You don't -- those extras will come.
When starting out, think of your limited home equity money as seed money to get you to that next level.
It's your passion and drive that will take you to the top, not an over-the-top, outsized loan that you'll likely squander on things you don't need.
You have worked hard to create your home equity and have certainly earned the right to put some of it to work.
However, you choose to tap your home equity -- receiving your money in a lump sum or in the form of a draw up to a certain limit -- use this finite and precious resource with extreme care.
Be a responsible borrower.
And, that's the point. There are many, many uses for your equity, so choose wisely.