When Does a Home Equity Loan Make Sense?

Home equity loans are so tempting. Every bank tries to sell them. If you’ve lived in your house for years, that amount can come to a very large sum. Plus, the line that “the interest may be tax deductible” is all too much.

Yet the burst of the housing bubble revealed a very dangerous aspect. If they resale value of your house drops, an all-to-real possibility these days, your house may become “underwater”, meaning that you owe more on it than it is worth. This makes refinancing impossible and moving almost so. The government will only help on two occasions: you are at least six months behind on your mortgage and foreclosure is imminent, or if you are moving and have are in a verifiable financial bind. Both will shred your credit sore.

There are a few questions you should ask yourself before you take the plunge and raid your largest nest egg.

  • Am I borrowing more than 90% of the equity, the minimum needed to sell the house without laying out cash?
  • Is this a long or short term loan?
  • How expensive are other methods of borrowing?
  • How much longer will I be in my house?
  • What are the chances of having to move?
  • Can I afford the minimum payments in an emergency?

There is no perfect formula of the above questions to tell you “No, now is not the time”. Here are some sample situations where a home equity loan makes sense:
You are going to improve the property.

Does your kitchen drive you crazy? Do you need an addition for space? Are you going to upgrade the heating system? Is your roof falling apart? Even solid landscaping can save you time and energy while increasing your enjoyment of the property.

Many home improvements actually increase the value of the house, or at least maintain it. So the risk of going underwater is somewhat less. They also increase your investment in the house for tax purposes. When you sell the house, you add the price of such investments to your buying cost, and save on the capital gains bill that the government will charge.

If you’re selling the house immediately, this is risky but sometimes necessary business. Most home improvements will almost pay for themselves on sale. For example, if you spend $10,000 replacing your deck, you can only expect the value of the house to go up $8,000 (upgrading your kitchen is the exception to the rule). Yet if you are going to have cookouts on that deck for the next 5 years, it’s worth the money. Maybe you should consider a built in grill or hot tub as well.

Paying for college.

If it is you that’s going back to school, make sure that your salary at the end will be more than the salary at the beginning before you raid the equity in your house. The starting salary in many careers can be lower than a working-class job you’ve been at for a decade, and the mortgage payments might limit your job choices and your ability to move to new opportunities.

If you son or daughter is going to college, it’s another matter. Unlike any 529 account, the interest on your mortgage is completely stable. Adding extra to your payment over time will save you interest as you go. Plus parent loans have high payments that start immediately. A home equity line of credit, or better yet a refinance, can help you take advantage of the equity in one fell swoop and spread the payments over a longer period. If you’ve made enough progress on your prepayments or it’s a good deal, it might even result in no increase in your payment at all.

Paying off High-Interest Credit Cards

This one seems obvious. Credit card costs are terrible. But if you do this, cancel the credit cards! Otherwise you’ll find yourself in the same situation all over again. Been there, done that.
Medical Expenses
Victor Hugo said in Les Miserables (the book, not the musical) that the only thing sadder than no money for food is no money for medicine. If the person being treated is you or your spouse, or you’re near retirement, make sure you have a plan for living expenses afterwards. It might be a downgrade in your standard of living, but time has no price tag.

To Invest in Higher Interest Opportunities

J.P. Morgan, a truly wise man of wall-street, said that you should never invest beyond your sleeping limit. In other words, if you can’t sleep at night, you’re investment risk is too high. If the investment isn’t particularly high-risk, however, or if your house just went up in price, using it as leverage for investment is a solid option. Just make sure that your short-term emergency fund is adjusted for the higher payments.

One reason NOT to take out a home equity loan is to have money to live on. If you’re still working, sell the house and move. If you’re retired and need more income, consider a reverse mortgage (check out the lender thoroughly). Borrowing money to live on is a good way to lose your house completely.

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