Home equity sometimes better left untapped

“Those who cannot remember the past are condemned to repeat it” - George Santayana, U.S. philosopher (1863-1952)

In recent weeks, I’ve seen and heard a lot more chatter surrounding home equity loans. Apparently, positive movement in many real estate markets (I know, I know, definitely not all parts of the country) has fueled renewed interest in this financial tool. As a financial planner with what remains a fairly sharp memory, I’m interested in making sure you don’t wander down the wrong path when it comes to using this helpful – but potentially dangerous type of debt. The bottom line is in doing so, you potentially put the roof over your head in peril.

First, let me say that using your own money is a better alternative than borrowing – whatever the source or type of loan. That’s why I’m a big proponent of building an emergency fund (not an emergency line of credit) and a savings and investment program designed to help you meet your goals – from vacations, to cars and college, and ultimately retirement. However, I’m not so naïve to think this always happens or can happen, so let’s look at the basics of borrowing based on the equity you have in your home.

Although this is probably not a shocker, you need to have “equity” in order to tap this type of loan. In other words, you need to owe less than the fair market value of your house. In the not too distant past (please see quote above) you could get an equity loan with little or no real equity. Thankfully, as a result of all the negative happenings in the real estate world, the equity requirements and the appraisal process have tightened up considerably.

You can tap your equity by way of a loan or a line of credit. With a loan you receive a lump sum payment, a fixed interest rate and repayment schedule over some period of time, say five, 10 or 15 years. A line of credit is typically an open ended line of credit with a variable interest rate and payment. So, if you know how much you need, would prefer to lock in a low interest rate, or like a fixed beginning and end, a loan makes sense. However, if you’re working a home improvement project and making payments to contractors over time, a line of credit may be ideal.

There are several reasons why this type of debt can be attractive to you, the borrower. First, interest rates are typically relatively low. Second, the interest is normally tax deductible if you use it for home improvement – and generally even up to $100,000 that is not used to improve your home. This makes your effective interest rate even lower. Finally, it gives you a means to tap into what may be one of your largest assets. But, do so with caution. Before you make a decision, consult with a tax advisor to seek advice based upon your particular circumstances.

Whether a loan or a line of credit, I think there are actually very few situations that actually justify tapping the equity in your home. Clearly, actually acquiring or improving the property would be a reasonable justification for using a home equity loan. Sometimes you can use a home equity loan to borrow a bit more than 80 percent when you’re purchasing your home and still avoid Private Mortgage Insurance, also known as PMI. You can also mark down that room edition, the new deck, or a kitchen upgrade as feasible. You could look at it as a tool (after comparing with other options) for funding higher education – although I’d still be more inclined to let junior get a job or loan.

Okay, I’m done with the situations for which I think using your home equity makes sense. Notice there was no discussion of cars, cruises or gasp, clothes. And having been through the “I’m going to consolidate all my credit card debt, fail to change my spending habits and finish with a home equity loan AND massive credit card debt” scenario with a few of my own clients, I purposefully did not include debt consolidation on my list of sensible solutions. Although, with fundamental changes in financial habits or extenuating circumstances that created the debt, I might be persuaded.

We started by quoting Santayana, so keep in mind he also said, “Advertising is the modern substitute for argument; its function is to make the worse appear the better.” So, don’t succumb to the home equity hype. Proceed down the path of tapping your home’s equity cautiously.

This material is for informational purposes. Consider your own financial circumstances carefully before making a decision and consult with your tax, legal or estate planning professional.

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