You may be snowbound now, but spring is around the corner. With home-improvement projects looming, anticipation of summer vacation growing or bills just piling up, many people are looking at how they’re going to pay for it all.
Rebounding home values may tempt many to view their houses as potential ATMs. Home prices, generally up since the Great Recession, rose 6.3 percent in the 12 months through November 2015, the Federal Reserve Bank of New York says.
While they’re tapping equity again, homeowners are being prudent, Todd Pietzsch, spokesman for BECU, Washington state’s largest credit union, said in an interview, echoing similar observations from around the country.
Although nearly 1 million homeowners in 2015 refinanced their homes to take out an average of $60,000 in cash, they didn’t borrow as much as they could have, says Black Knight, a financial services firm that analyzes mortgage data.
Financial experts say there are smart ways and dumb ways to use home loans. Let’s take a look at things you should ask yourself first.
1. Why am I borrowing?
“Historically low rates mean a home equity loan or line of credit could be a great idea, providing the money is being used for a legitimate purpose, one that will ultimately add to your net worth,” advises Money Talks News financial expert Stacy Johnson. “The last thing you want to do, however, is use your home equity like a piggy bank to live beyond your means.”
If you don’t maintain home loan repayments, you could literally lose the roof over your head, he warns.
“There’s an old expression in the credit counseling industry: ‘Buy a blouse, lose a house.'” Johnson says.
Sometimes unplanned major expenses come up, such as medical bills, another common use of home loans, analysts say.
To guide yourself, the first question you should ask, says BECU spokesman Pietzsch: “How will taking this loan move me closer to my financial goals?”
“Borrowing for the dream vacation or other things that will only depreciate quickly may not be the best use of a loan,” he says.
Whatever you decide, have a repayment plan and understand that interest charges, depending on loan terms, could be a larger expense than the amount you borrow.
2. Is my home improvement project worth it?
“As home values have improved, members have equity that they are putting to use to take care of many of the things that they had to put off until housing prices rebounded,” Pietzsch said. That includes home improvements such as a new roofs, kitchen remodels and deferred maintenance.
3. Should I consolidate debt?
If you’ve run up high-interest credit-card debt, you may be tempted to get a lower-interest home loan that’s typically tax-deductible to pay off your debt with one smaller monthly bill.
“Debt consolidation is by far the most common way home owners use home-equity loans,” says Realtor.com.
The new loan payment may be less than your old monthly bills combined, freeing up cash for saving or buying necessities.
The problem: Many people go on spending in ways that got them in trouble in the first place. If you go this route, consider closing most accounts and cutting up all but one credit card to use in a real emergency. Otherwise you might find yourself trying to pay off the home loan at the same time you’re trying to keep up with new debt payments.
If you fall behind on the home loan you took to consolidate bills, you will be in danger of losing your home.
4. Should I pay off a student loan with a home loan?
Paying off a higher-interest student loan with a lower-interest home equity loan sounds appealing but is fraught with risk, warns the Consumer Financial Protection Bureau (CFPB). Putting more debt on your home can lead to problems down the road. If you can’t pay back the home loan, you could end up in foreclosure.
Federal student loans feature protections, including Income-Based Repayment, for borrowers who run into trouble, the bureau says. These benefits evaporate when you pay off a federal student loan with a home equity loan.
Look first for a student loan refinance product and see what rate you can get, the bureau says. You may be able to lower your interest rate without some of the risks that come with tapping the equity in your home.
On the other hand, the interest you pay on a home equity loan could bring a greater tax deduction than a student loan interest tax deduction, especially if you have high income and itemize deductions, the bureau says. Consult a tax adviser.
5. Should I invest in myself?
Advancing your education is one way to invest in yourself that may pay off in higher income later; however, there are alternatives to home equity loans to explore first.
Federal student aid from the U.S. Department of Education can help you cover your expenses regardless of your age if you attend a college, career school or graduate school.
Also, before deciding, compare tax advantages of a home loan against benefits from federal income tax credits for education expenses, as shown in IRS Publication 970.
6. What type of home loan is right for me?
While banks and credit unions offer a variety of home loan programs, they basically boil down to three ways to pull cash out of your home:
Cash-out home refinance: Replace your existing mortgage with an amount that covers how much you still owe plus the amount of cash you want to pocket — plus settlement costs. The loan likely comes at a lower interest rate than a home equity loan. A refi works best if the interest rate on your new loan is less than the rate on your current mortgage.
Home equity loan: Sometimes referred to as a second mortgage or junior loan, you are borrowing on the equity you have in the home, or the difference between what the home is worth and how much you still owe on the first mortgage. Pre-financial crisis, loans were often made for 125 percent of your equity; now, borrowing only up to 80 percent of your home value is likely.
Home equity line of credit (HELOC): This revolving form of credit uses your home as collateral, but you only borrow as you go, rather than pulling out a lump sum. You can borrow and pay back as many times as you’d like during the draw period. After your draw period ends, you no longer borrow and you repay whatever you owe. Draw periods and repayment periods vary by loan program; for example, maybe your draw period is five years, and your repayment period is 10 years.
7. How much may I borrow?
How much you should borrow on your home depends on how much cash you really need — and how much is available. In an example from BECU’s Pietzsch, the maximum loan amount relative to the value of your home usually is 80 percent. You may want less.
If you owe $100,000 on your home that is appraised for $200,000, you may be able to get approximately $60,000 in cash through refinancing, he says.
8. What’s better: Selling assets or borrowing money?
Calculate your situation carefully if you’re trying to decide between borrowing against your home or selling an asset to raise cash. If you sell a used car or boat, you likely have to worry only about your state’s sales and personal property taxes, where applicable, as the value of these possessions likely depreciated while you owned them.
But say you want to sell stock. Even the simplest comparison may be complicated.
Say you had 1,000 shares of Microsoft stock that you could sell for $49.50 a share, a price within its recent trading range. Great, you might think, there’s $49,500. If the stock were valued at only $39.50 a share when you bought it a few years ago, or $39,500, that, in simple terms, would be a capital gain of $10,000. Under IRS rules, typically you would owe a 15 percent capital gains tax, in this case, $1,500. You would also give up receiving stock dividends, which this year are estimated at $1.44 per share; if they were unchanged for 10 years, those dividends would total $14,400, on which you would owe income tax as regular income, typically at an effective rate of 5.3 percent for a middle-income family of four; so you would have realized about $13,637. So you could consider the 10-year cost of selling your stock as $15,137, not just the $1,500 capital gains tax alone.
Instead, say you took out a home equity loan of $49,500 with terms of 10 years at 7 percent interest. At the end of 10 years, you would have repaid $58,810, of which $9,310 would be interest, according to an online loan calculator. In theory the interest payments would be deductible on your federal income taxes, yielding a small tax benefit each year of the loan repayment period, too.
Consult your tax adviser to see what’s best for your situation.