When Is It Appropriate to Tap into a Home Equity Line of Credit?

What is a Home Equity Line of Credit?

Part of the value of home or property ownership is the ability to build credit and make money on it as an investment.

We normally think of the real estate itself as being the value-building asset after we acquire it. But it’s also possible to make money based on the difference between the market value of the home and the outstanding loan balance you still owe against it. Translated, this means your home’s value minus the mortgage balance. This difference can be borrowed against as a home equity loan.

This financial asset can allow you to withdraw funds, or borrow, to pay for other things. For example, if you’re starting a small business, you can borrow from your home line of equity to invest in something else for your financial future. This can be a delicate and potentially risky strategy if done wrong or frivolously; when done right, it’s a smart way to borrow against an asset to achieve the rest of your financial goals. This is referred to as a taking out a second mortgage on your property. Mortgages have repayment periods ranging from 10, 15, 20, or 25 years; longer payment periods have smaller due payments but take longer to build equity.

Some common financial products using access to home equity include:

  • Home equity loans
  • HELOCs (Home Equity Line of Credit)
  • Cash-out refinance

Home equity loans and HELOCs both offer you loans that are secured against the equity value of your home. As they are secured against the value of your home, these loans can offer variable but potentially highly competitive interest rates. Other financing options, like credit cards, will not offer such secured borrowing and will have much more interest, which means you pay more for the same borrowed value over time. But the downside is that a home equity loan offers your home up as collateral, which can prove very risky depending on the nature of the investment. The risk increases the more you borrow against the value of your home.

Like with most loans, there are different terms, repayment options and schedules, and variable rates to take into account when tapping into a home equity line of credit. Not every investment is a good idea to borrow from your home’s equity on, and knowing the difference between a beneficial expenditure and an unneeded one can make a huge impact on your financial future.

When Is It a Good Idea to Borrow Against Your Home Equity?

Home equity loans can be used for expenses that need to be paid quickly. Many people use them for things like home renovations, weddings, or other life necessities that can also be financially valuable going forward. Though home loans are rapidly distributed at fixed rates so you know what your payments will be, it’s usually best for larger infusions of cash than smaller ones. Many lenders won’t issue a home equity loan for less than tens of thousands of dollars, meaning you have to have a suitable project or goal of a large enough financial size to make the loan worthwhile and beneficial.

People can run into trouble by taking out a home equity loan without any real goal or concrete plan for repayment and credit building. Simply taking out the money to have it isn’t a good call; there are other ways to build credit and pay off certain bills or everyday items that don’t require a potentially risky borrowing strategy. Many purchases can be made on normal credit cards to earn more points or cash value that helps your personal finances; this should be pursued before attempting a home equity loan.

If you do need something with a more revolving fund source, a home equity line of credit (HELOC) is a better choice. This is a good way to pay for emergency funds, especially during times of crisis; they also offer variable interest rates. There are different phases to a HELOC, including a draw period and a repayment period. Draw periods, usually around 10 years in duration, can have an extension if needed before entering the repayment phase. During the repayment phase, you are no longer able to access funds from the loan.

HELOCs have interest rate payments that increase during the repayment period, which can prove a financial hardship for those who aren’t financially secure after the draw period ends, depending on the size of the payments and the terms. A second mortgage can be a useful loan for building even more assets, especially in the home itself, such as for a remodeling project or needed renovations that increase the value.

Part of the risk to a home equity line of credit or a second mortgage is that the interest and repayments are contingent on often unpredictable market factors. Your home can appreciate or depreciate in value given the housing market. For instance, in 2008 during the housing crisis, the value of homes decreased, on average, by 9.5%. But in 2021, they increased by 14%—that’s a lot of variance for home value, especially when your payments are tied to these figures. 

You can also get a cash-out refinance, where you take out a new loan to replace the original mortgage. Though the interest rate is generally lower with a refinance, the up-front closing costs are much higher than any other loan. Depending on your equity value, you might also have to spring for more private mortgage insurance (PMI).

As the financial differences between types of home equity loans are more pronounced depending on needs and goals, it’s important to have a concrete plan for whatever loan you’re requesting and how you’re going to use it. You should also have a clear repayment plan and the ability to pay back whatever you borrow while taking into account possible fluctuating interest and market rates. A HELOC means another lender has a lien on your home, for example, so falling behind in your payments can mean you face foreclosure.

The mistake most people make is not fully understanding the terms and conditions and falling behind in payments or not setting goals for themselves and their repayments. But if you set a budget and use the financial advising and resources available to you, a home equity loan, HELOC, or refinancing plan can be a terrific way to further expand your financial horizons.

Please reach out to a GNB Mortgage Lender for additional information if you are interested in a HELOC.