Back in 2005, this was on the radio all the time: “take the equity out of your house and put it to use.” The announcer would tell you everything you could do with that money that was locked inside your house like a vein of gold just waiting to be mined.
Only here’s what they didn’t tell you: you weren’t “taking out equity;” you were taking out a loan, and loans must be paid back.
What is EQUITY?
Equity is the difference between your home’s fair market value and the outstanding balance of your mortgage. In other words, it’s the amount of the house that you own, rather than the bank. For example, if you have 20% equity in your $200,000 home, then the bank owns the remaining 80% of the house.
If you “take out the equity” – or give up your 20% ownership – where does the money come from? A BANK! A bank loans you the money and your debt increases by that amount. Bankers call them Home Equity Loans.
Smart Tips on Home Equity Loans
Kim Martin, a very experienced banker with Capital West Bank in Fort Collins, has some home equity loan tips for you.
- Start with a HIGH amount of equity in your home – don’t do it if you have less than than 20% equity in house
- Keep at least 20% equity in your house – don’t borrow more than that
- Pay yourself back ASAP – in a couple of years, if possible
Interest Rates on Home Equity Loans
Many people are not aware that you pay higher interest rates on home equity loans than mortgages. For that reason, the price tag on home equity loans adds up fast. For example, let’s say you borrow $10,000 at 6% for 10 years. Amortized over the term of the loan, you will pay $3,322 in interest.
Because it is expensive money, Kim Martin recommends that you be very careful with home equity loans. Only take them out for really good reasons.
Good Reasons For Home Equity Loans
Here are a couple of good uses for home equity loans.
- Sensible Remodel Projects – Kitchen and bath remodels are best because you get dollar for dollar payback, or close to it. Make sure the projects are in keeping with your neighborhood.
- Investment Property – Use your equity for down payments on rental property. This is “good debt” because your tenants pay the mortgage for you (assuming your investment cash flows).
Dumb Uses of Home Equity Loans
Back in the 2000’s, people would take out home equity loans for all manner of bad reasons:
- Toys – boats, motorcycles, trucks, campers
- Home Over-improvements – “dream projects” beyond the scope of the neighborhood, such as pools, spas, professional-grade shops, lavish bathrooms and kitchens, tricked-out basements
- Risky Investments – stocks, businesses
- Loans to family members
The best rule of thumb is, if you can’t pay cash for vacations and toys, don’t buy them. Wait until you save the money; don’t mortgage your home and your future on a trip to Mexico.
Maybe There Is No Other Option
Sometimes people find themselves in really tough situations and they turn to their home equity when there is no other option. Common reasons are huge medical bills and college tuition. If you find yourself painted into a corner, just be very cautious because, for many people, such moves only delay the inevitable; often they lead to bankruptcies and financial disasters.
When Home Equity Loans Catch Up With You
All good things must come to an end, so they say, and it’s true with home equity loans. It catches up with you when you sell your house; the loans come due and must be paid off. I’ve sold several houses where people had zero or very little equity. Usually the sellers come to the Closing with a check to settle their debts.
So be careful when you hear ads on the radio touting what all you can do with that equity in your house. If it sounds too good to be true, it probably is.