Lenders want you to borrow against your home equity again. The question is, should you?
Rising home values and a sluggish mortgage market mean banks are once more marketing home equity lines of credit. Last year, lenders handed out $156 billion in HELOCs, a 24% rise from a year earlier and a 138% rise from 2010.
HELOCs are typically a cheap source of credit, with current rates averaging less than 5%. (Here’s how to pick the right HELOC lender.) But borrowing against your home equity can be risky. Rates are typically variable, and payments can balloon after the initial interest-only period ends. A recent uptick in second mortgage delinquencies is being driven by an 87% jump in missed payments from loans made in 2005 that just ended their 10-year interest-only period, according to Black Knight Financial Services, which tracks mortgages.
Less equity also means less cushion if your home value drops, leaving you more vulnerable to foreclosure if you lose your job or otherwise can’t pay the loan.
There are times when taking the risk can make sense, but only with certain caveats. You normally don’t want to borrow more than 80% of your home’s current value, a ratio that includes your first mortgage. You’ll typically get better rates and terms, plus you’ll be left with a cushion for emergencies.
What you spend the money on matters as well. Here are five uses for home equity that can make sense:
1. Home improvements
But only if they actually add value and you pay cash for up to half the cost.
Few home improvements will increase the value of your home enough to cover their cost. Many projects return between 50 and 80 cents on the dollar, assuming you sell within a year of completing the project.
Borrowing only half the cost of a remodel and paying cash for the rest can help you curb the urge to overspend. It also lessens the odds of paying interest for years on borrowed money that didn’t enhance the value of your home.
Speaking of years, a HELOC is probably your best option if you can pay it off within a few years. If repayment would take you five years or more, consider other options including locking in a fixed rate with a home equity loan instead.
2. Debt consolidation
But only if you’re extremely responsible and can pay off the balance fast.
There are many, many problems with using home equity to pay off credit card and other high-rate debt. One of the biggest is that you’re turning consumer debt that could be discharged in bankruptcy into secured debt that can’t.
Another is that you may just be papering over a spending problem that will leave you deeper in debt. If you don’t fix the budgeting problems that led to the credit card bills in the first place, you’ll soon find yourself with a HELOC balance and more credit card bills.
If you’ve mended your ways and can pay the HELOC off quickly — say, in three years or less — it may be worth the gamble. If it would take you five years or more, though, you may have too much debt for a do-it-yourself solution. Consider other alternatives, including talking to a credit counselor or discussing your situation with a bankruptcy attorney.
3. Emergency expenses
But only if it’s a real emergency and you’ve exhausted your nonretirement savings.
Financial planners typically recommend an emergency fund equal to three months’ worth of expenses or more. Unfortunately, it can take a typical family two years to save up that much, and a lot can go wrong in the meantime. A HELOC can supplement an inadequate emergency fund and be a comforting Plan B while you build or rebuild your cash stash.
4. College costs
But only if you’re the parent and can pay off the balance before you retire, while still being able to save for retirement.
Students have access to federal student loans, which come with low fixed rates, numerous repayment options and the possibility of forgiveness. Parent PLUS loans, by contrast, come with higher rates, an origination fee over 4%, fewer repayment options and no hope of forgiveness.
HELOCs can be a reasonable alternative, especially if the parent can pay off the loan relatively quickly. Again, if it would take five years or more, fixing the rate with a home equity loan could make more sense.
If borrowing would keep you from retirement, though, consider other alternatives — like a cheaper school.
5. To protect your portfolio in retirement
But only if you open a reverse mortgage line of credit early in retirement for just this purpose.
Good financial planners have long hated reverse mortgages, which allow people 62 and over to tap their home equity without having to make payments on the debt. Advisors traditionally have seen these loans as a last resort for retirees who exhaust all their other assets.
Today’s reverse mortgages are cheaper and safer than in the past, however, thanks to improvements in the Federal Housing Administration's Home Equity Conversion Mortgage program. Also, recent research indicates that reverse mortgage lines of credit offer an important safety valve in retirement. When the stock market plummets, retirees can tap credit lines instead of their portfolios, which allows their investments time to recover when the market rises. This “standby reverse mortgage strategy,” as some researchers call it, significantly improves the odds of a portfolio lasting through retirement.