Home equity lines of credit usually have low interest rates, so they can be an intriguing option if used in the correct way.
With home values rising, more Americans have equity in their homes. That has generated plenty of cheers from homeowners, and it’s also brought back the home equity line of credit as a popular option for the first time since before the Great Recession.
Americans took out $23.4 billion in home equity lines in the first quarter of 2014, up 15.5 percent from 2013 and the highest number in six years, according to Equifax, a credit reporting agency.
If your mortgage is less than 80 percent of your home’s value, you might want to join that group. But the greatest lesson of the recent real estate boom and bust is that turning home equity into cash is best done with great care.
“The mortgage mess and the real estate recession gave us some really good lessons in how home equity lending could go bad,” says Liz Weston, a personal finance columnist and author of “Deal with Your Debt: Free Yourself from What You Owe,” and other books. She cited a 2011 CoreLogic study that found that borrowers with home equity loans or lines of credit were significantly more likely to owe a larger amount than their homes were worth.
“We shouldn't forget those lessons now that many people have equity again, and that banks are allowing us to tap it. Your home equity is a precious resource that shouldn't be squandered,” Weston says.
There are times that having a home equity line of credit is a smart financial move.
It’s hard to find a loan at better rates – less than 4 percent for borrowers with good credit – and qualifying for a home equity line of credit is easier than it is for a business or personal loan. Having a home equity line of credit but using very little of it can help prepare for emergencies, Weston says.
“Even a fat emergency fund can get drained by a big-enough financial setback, and most people don't have a fat emergency fund,” she says. “The key, though, is, again, not to squander that equity. You want it there for you when you need it. If you're such a spendaholic that you can't trust yourself not to use the line, then of course you shouldn't set one up.”
Using home equity line of credits to finance cars and vacations is generally a bad idea, financial experts say. Using the line to fund a child’s education might be a good idea, but only if you can pay it back in five to 10 years.
“I think what we learned with the last housing boom is that there’s a danger in tapping home equity,” says Daren Blomquist, vice president at RealtyTrac, which tracks and analyzes housing data. “That equity is really an ethereal thing. In a sense, it’s not real.”
Property values have risen significantly in the last few years, which has added to Americans’ home equity, but while home values have increased, the pace of growth is now slowing, he says. “You have to be careful you’re not treating that home equity as an unlimited source of funds,” Blomquist says.
The safest use of home equity funds is for home improvements that will add to the home’s value. If you spend $50,000 on a home addition that adds $50,000 to your home’s value, you’ve broken even – though you still have to make payments on the money you borrowed.
During the real estate boom, many investors, and even some individual homeowners, drew on their home equity to buy additional properties, keeping these properties heavily mortgaged. When home values dropped, many investors lost all their properties due to the risky real estate game they were playing. “Leverage can be an amazing tool for an investor, but it can also be an entirely dangerous tool as well,” Blomquist says.
If the only funds you have to draw on for investment are your home equity, you may want to reconsider, Weston says. “Home equity lines can be a cheap source of credit, but you're putting your home at serious risk,” she says. “The only way it makes sense to me to borrow to invest is if you have enough savings to pay off the debt in a hurry if you have to.”
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