Nationally, home prices are up more than 5 percent through the first half of 2016, and many markets are close to their all-time peak, according the real estate information company Zillow. As a result, millions of people are borrowing against the equity they've built up in their home since the housing crisis.
According to data from Freddie Mac, 41 percent of consumers in the second quarter of 2016 took out mortgages that involved some form of cash-out refinance, or borrowing against home equity. In all, homeowners borrowed more than $13 billion of their home equity between April and June. That is up from $11.4 billion in the first three months of the year, when 38 percent of homeowners used the cash that had accumulated in their home’s value. Those percentages are more than double the mortgage borrowers who borrowed against their home’s value during the housing crisis, which was just 15 percent.
If a homeowner is considering borrowing against their home equity, there are questions that should be asked first. Without taking careful consideration when borrowing against the value of a home, a consumer could end up in a weaker financial situation in the long run.
Here are three questions to consider before tapping home equity:
- Are you borrowing for an investment?
- Are the terms clearly spelled out?
- Is there a contingency plan if the home’s value declines or loss of job?
Are You Borrowing for an Investment?
The best thing to do when using home equity is to use the money for a project or activity that will add value to your home. Using home equity to finance a vacation or other short-term consumption is generally a bad idea. Remember, the vacation is over in a couple of weeks, but the loan could linger for years.
A better way to finance a short-term goal like a vacation is to establish a savings plan and stick to it. However, a national survey conducted by NeighborWorks America in April 2016 found that 61 percent of Americans didn’t have a formal budget, which makes it difficult to establish a savings plan.
A better use of a home equity loan is to reinvest the money back into the house with the intent of increasing the long-term value of the home. Not all home improvements provide the same long-term payoff when the home is sold, so you should weigh your options and make a decision based on your needs and the value the project adds in the long run.
Investing in education is another generally good use of home equity. With student loan debt nationally exceeding $1.2 trillion, being able to pay for an education out of home equity is a traditional and long-standing good move. But taking on debt of any kind – home equity or a student loan – without fully understanding the terms could be a recipe for disaster.
Are the terms clearly spelled out?
Setting the right objective is only half the job when choosing to borrow money based on home equity. Choosing the right type of loan is also important. There are two ways a homeowner could borrow home equity: A home equity loan or a home equity line of credit, often called a HELOC.
A home equity loan allows a homeowner to borrow a fixed amount for a set term and with a fixed interest rate. Home equity loans usually require principal and interest payments each month, just as a standard mortgage does.
A HELOC gives a homeowner access to a flexible amount of money with an upper limit, similar to a credit card, at an interest rate that is variable. The variable or adjustable interest rate could work in a homeowner’s favor if interest rates decline, reducing the monthly amount a borrower pays the lender.
However, interest rates may also go up, perhaps faster than a homeowner’s income increases. In addition, typical HELOCs allow for only repayment of interest for a period of time.
Making interest-only payments seems to make the loan more affordable – but that is misleading. Sooner or later the principal has to be paid back, too, and not just its interest. If you don't take the principal into consideration early on, it could lead to a major financial shock down the line.
Consulting with a third-party financial coach or financial planner about the details of the loan, its terms and how the loan fits into a long-term plan is a good step to follow. A financial coach or planner could also caution against using too much home equity.
[See: 10 Tips to Sell Your Home Fast.]
Is There a Contingency Plan If Home Values Decline?
The housing crisis is largely over in most communities across the country, but some housing experts think the steady increase in home prices the past few years, particularly in selected cities, is a prelude to another bust in home values.
The best thing a homeowner can do when tapping into home equity is to have a contingency plan, in case you lose your job or have to sell your home at a time when values have declined. Traditionally, home equity has been used as a financial cushion in an emergency. But if the equity has already been used, that cushion is gone.
Having a contingency plan in place in case of job loss is essential to helping a homeowner remain current on her mortgage while looking for new work. A NeighborWorks survey published in March found 30 percent of adults have no emergency savings, but slightly more than 8 out of every 10 middle-income homeowners had some emergency savings.
There are many things to consider before borrowing against the equity in your home, and most mortgage-related conversations are complicated, which is why it's best to be prepared and do your homework. Going into the transaction informed about loan choices, with a clear plan that adds value in the long run and a contingency strategy if things go awry are prerequisites to help ensure your decision is a good one.