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Understanding Home Equity: When to Tap and When to Hold Off

Equity represents the difference between the current market value of your home and the amount you owe on your mortgage. It can be a valuable asset to access cash when you need it. For homeowners with significant home equity, especially after recent increases in home values, tapping into this equity might seem enticing. According to the Federal Reserve Bank of St. Louis, the median home price has risen from $327,000 just before the pandemic to $436,800 in the first quarter of 2023.

However, accessing your home equity isn’t always advisable, particularly when interest rates are high or if you plan to use the proceeds for non-essential expenses like vacations. Home equity loans and home equity lines of credit (HELOCs) are secured by your home, meaning you could lose your home if you fail to make the monthly payments. Therefore, it’s crucial to proceed cautiously. Here are six reasons to reconsider tapping into your home equity.

1. High Interest Rates

Currently, we are experiencing a period of high interest rates as the Federal Reserve has increased rates multiple times since March 2022 to curb inflation. When the Fed hikes interest rates, rates on home equity products also tend to rise. Even in times of low interest, rates on home equity loans, HELOCs, and cash-out refinances are typically higher than primary mortgage loans. Most HELOCs and certain types of mortgages come with variable interest rates, which means you won’t be protected from future hikes. If rates rise significantly, making your payments could become more challenging.

2. Non-Essential Expenses

Borrowing money for significant expenses like a dream vacation or wedding may not be the best strategy. While these expenses may be important, they don’t improve your financial health. Think carefully before borrowing money to cover optional expenses. These experiences are short-lived, but the debt you incur can last for years or even decades. The money you spend on loan payments might be better spent elsewhere, such as for your retirement or building an emergency fund.

3. Paying College Tuition

You likely have better options to pay for higher education than leveraging your home’s equity. Aim to exhaust all available scholarships, grants, and federal student aid before turning to more costly loan options like private student loans or home equity loans. Federal student loans generally come with lower interest rates than home equity financing, flexible repayment plans, and potential student loan forgiveness. Given the risks, tapping your home equity to pay for school may not make sense.

4. Investing

All investments come with a certain degree of risk, but risking your home to invest in real estate or the stock market is not your best option. Leveraging home equity to purchase rental properties may work out when rates are low and property values are rising, but it’s no guarantee. Similarly, using your home equity to invest in the stock market isn’t a surefire strategy. If your investments take a hit, you could lose the home equity you’ve invested and still be saddled with the debt.

5. Buying a Car

Home equity loans and HELOCs offered much lower interest rates than car loans in recent years. However, the repayment term length makes a significant difference to your bottom line. Auto loans are usually paid off within five or six years, while home equity loans can take up to 30 years to pay off. That means you could pay much more in total interest over the life of the loan. Remember, cars depreciate quickly, and you could end up owing much more than the car is worth and continue to pay it off long after you’ve stopped driving it.

Alternatives to Tapping Into Home Equity

Given the potential risk of foreclosure associated with home equity loans, it’s crucial to explore other saving and financing options that don’t put your home on the line, such as:

• Set up a dedicated savings account: Set up an automatic transfer to a high-yield savings account for specific expenses like a vacation, wedding, or car. Small deposits can add up over time and help you cover a significant expense without risking your home.
• Borrow from a close friend or relative: Borrowing money from someone you know can be uncomfortable, but it often provides the most favorable terms. Set up a written contract that outlines the loan amount and repayment schedule and honor your agreement.
• Direct unexpected windfalls toward savings: Allocate unexpected money, like tax refunds, work bonuses, or an inheritance, towards your goal.
• Explore opportunities to earn extra income: Consider ways to earn extra money, such as a part-time job or side hustle, volunteering for overtime at work, or selling items you no longer need.
• Consider other finance options: Most personal loans are unsecured, meaning you don’t have to provide collateral such as your home. While unsecured loans have higher interest rates than home equity loans, they don’t put your house at risk. Likewise, if you have good credit and want to consolidate your debt, a balance transfer credit card with a 0% APR introductory offer could be an option.

The Bottom Line

While home equity products can be valuable tools to gain access to the cash you need, the risk you take on—your home—is considerable. Before you tap into home equity for any reason, carefully evaluate the risk. Be aware that if your circumstances change and you can’t make your payments, you could potentially face foreclosure and lose your home.

If you do decide to take out a home equity loan, line of credit, or a cash-out refinance, check your credit report and credit score to get an idea of your current credit status. Consider taking steps to improve your credit before applying for a new loan.

For any mortgage-related needs, call O1ne Mortgage at 213-732-3074. Our team is here to help you make informed decisions about your home equity and other mortgage options.

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