It’s time to enlarge the kitchen, add that fourth bedroom before the new baby arrives, or book the summer beach house on the Outer Banks you’ve always dreamed about.
It’s spring, when many a man and woman’s thoughts turn to three magic words: home equity loan.
Home equity loans — tapping your house for cash — are more popular than ever. With the average interest rate on variable-rate credit cards at 16.93 versus 5.57% on home equity loans or 5.90% on home equity lines of credit, they’re a great option to make some well-planned dreams come true.
Generally speaking, banks will let you borrow 80% of the amount of equity you have in your home, but before you order the new granite countertops, you need to master a handful of essentials about home equity loans.
Here’s how you can get it triumphantly right and avoid what can go regrettably wrong.
- Learn how to calculate how much you can borrow
- Grasp the crucial difference between wealth and liquidity
- Understand home equity loans versus lines of credit
- Consider the new special tax value of home improvements
- Weigh the debt consolidation option carefully
- Avoid the risk and temptation of cheap, ready cash
How Much Cash Can I Squeeze out of My Home?
Calculating the size of your home equity loan is a straightforward three-step process. First, you need a home appraisal.
A full appraisal usually runs about $300 to $400, but in many cases you won’t need to pay for a new appraisal. If your equity loan is with your existing lender they often will use your old appraisal if it’s only six months or even sometimes a year old.
Banks also often will accept a limited scope appraisal. An appraiser paid by the bank does a drive-by and collects other information to estimate value.
Other lenders simply use a desktop model. They type your address into software that spits out a value based on comparable sales. Voila! Your house is worth $250,000, they say.
To qualify for a home equity loan, you’ll need proof of income, have paid off at least 20% of the home, and have a good credit score. In a recent study, 70% of people who closed loans had credit scores over 700.
Step two is to determine the amount of equity you’ve built up. The quick math looks like this: appraised value minus amount owed = home equity.
So, if your home is appraised at $250,000 and you owe $185,000 on your mortgage, you have $65,000 of equity in your home.
Step three is when you open the fortune cookie to learn … the size of your loan. It’s a simple formula. Your friendly banker gives you a loan for 80% of your $65,000 equity, which means you qualify for a $52,000 home equity loan (65,000 x 0.80 = 52,000).
The next big question: What should you do with your sudden $52,000 windfall?
If Someone Hands You $52,000, Are You $52,000 Richer?
The answer in a word: No.
This is important. You need to recognize that the $52,000 is not a windfall, says Todd Sinai, Professor of Real Estate and Business Economics and Public Policy at the University of Pennsylvania’s Wharton School.
It’s not wealth. It’s liquidity. There is a vital distinction.
“Home owners need to keep in mind that home equity is not wealth” in the traditional sense, Professor Sinai said in an interview with Debt.org.
“It’s not extra money that could be spent on other things.”
For example, Professor Sinai said: “If you buy some stock, and the share price goes up, you actually are wealthier because you could sell the stock and use the proceeds to buy something you wanted without giving up anything else.
“But, if your house has appreciated in value so you have a lot of home equity, you cannot sell your house to get the proceeds without giving up your place to live!”
Another way to look at it is: “Buying an equivalent house would cost just as much, so you don’t have any extra money.”
The only time that home equity is “wealth” is when you plan to move to a cheaper house, Professor Sinai said, or if you are a senior who won’t be in your house very long.
That doesn’t mean a home equity loan is not a good thing. Liquidity is cash you can use today, so long as you prepare to pay it back in the future.
Professor Sinai’s advice is this: “Treat your housing equity as the money you’ve set aside to pay for housing. That’s really what it is, and you will need all of it. Don’t tap into it for anything other than investing – so don’t spend it on TVs, cars, or vacations!”
Are Home Improvements a Good Use of Your Loan?
In a word: Yes.
Americans nowadays, even those without personal advice from a Wharton professor, use home equity loans to fund home improvements or repairs 32% of the time, according to a new study.
Call it the wisdom of crowds.
Hurry up on that fourth bedroom—most American babies are born during summertime, the season for hurricanes, and can raise the same havoc in a too-small house. September 9 is the most popular U.S. birthday!
Other homeowners tap into some emergency cash for a new car, a vacation, or a thousand different reasons, 14% of the time. And they cover education expenses 12% of the time. Not all these loans are a good idea.
Adding that bedroom, a high-efficiency furnace or new roof (compared to splurging on the big screen TV for the Super Bowl) makes sense because it’s a tangible gain in your lifestyle, but also an investment in your house.
Another good reason to spend the new cash on home improvement: You can deduct the interest paid on the home equity loan on your taxes.
In the good old days, all interest paid on a home equity loan was tax deductible. But not anymore. You get the deduction for as much as $750,000 borrowed to build or improve your house or second house.
There was so much confusion on this point with the new tax law, the Tax Cuts and Jobs Act of 2017, that the Internal Revenue Service recently issued an advisory: The new tax law eliminates the deduction for home equity interest from 2018 to 2026 — unless the loan is used to “buy, build or substantially improve” the home that secures the loan.
What’s the Difference Between a Home Equity Loan and a HELOC?
Both are home equity loans that feature interest rates much lower than credit cards.
The difference is this: you receive a lump-sum payment with a home equity loan and repay it in monthly installments immediately. A HELOC is a line of credit that you can draw from as needed and your repayment doesn’t begin until the end of your draw period.
Using the example cited above, with a home equity loan you receive your $52,000 all at once and make monthly payments with a fixed-interest rate. The repayment period usually is 5-10 years, but can go to 15.
It’s the choice of most folks looking at a big project, like that fourth bedroom or new kitchen.
A HELOC gives you more flexibility if you don’t want to spend a lump sum all at once. It’s like a credit card with a smaller interest rate.
You get a revolving line of credit to draw from, with your house as collateral, and you only pay interest on what you use. If you took your $52,000 as a HELOC, and used $6,000 for kitchen improvements, you’d only pay interest on the $6,000, and still have $46,000 to borrow.
Can I Use a Home Equity Loan or HELOC to Pay off the Dang Credit Cards?
That word again: Yes.
There are few cheaper ways to achieve debt consolidation than a home equity loan or a HELOC. (Even with the new tax law, which eliminates the deduction for the interest on your home equity loan if you’re using it to for personal expenses like paying off credit cards).
Talk to a federally-accredited, nonprofit debt counselor if you choose this route.
So What’s the Big Risk of a Home Equity Loan?
There’s little risk for the lender. That’s why he’s eager to make any type of home equity loan. It’s like a second mortgage he’s giving you on the house. He’s sitting pretty because he has your house as collateral.
That’s why he’s happy to give you a low interest rate because he’s covered if things go all wrong.
The big risk is if those things go wrong, like sudden unemployment, serious illness, a collapse in the value of your house, or if you treat the loan like a windfall of sudden new wealth and can’t make payments, you stand to lose the house.
Of course you can get into trouble with a revolving home equity line of credit, just like you can with a credit card, by borrowing and spending beyond your means.
If you can’t make the payments, the lender could foreclose on your house. Even the second lien-holder can initiate foreclosure.
“Confusing liquidity with wealth gets home owners into trouble,” Professor Sinai said. “All too often, people cash out their home equity and fail to adequately plan for paying it back.”