Home equity: use it wisely

February 1, 2008

There’s not really any single reason we could point to that explains why the housing market/ lending industry has been through such an upheaval.  Certainly rapidly rising home prices had something to do with it.  And the rise in risky loans, like interest-only and subprime loans played a part, too.

But the unwise use of home equity was a problem, too.

Home equity is the difference between the market value of your home and the amount you owe on it.  For example, if your home is market valued at $300,000 and you currently owe (including all mortgages and equity loans or lines of credit) $280,000, then you have $20,000 – or about 7% – in equity.

As home values rose rapidly, shady loan officers convinced homeowners to take out 100% (or more!) home equity loans on their homes.  If home values had risen 20% (as they did in many areas of Phoenix), even a homeowner who bought a home with no money down could take out a huge home equity loan.

Sometimes, instead of taking a home equity loan, which is a second mortgage, or a home equity line of credit, which is like a credit card with your house as collateral, people did a cash-out refinance, where they refinanced their homes, got a new adjustable-rate mortgage for 100% of the home’s value, and took the equity in cash to spend.

At the time, it all sounded like a great idea.  Some people used the cash to take trips they’d been waiting for their whole lives for.  Others paid off high-interest debt like credit cards.

But as home values fell, people found themselves owing more on that new mortgage or combined mortgage and home equity loan than their house was worth.  And for those who did cash-out refinances with adjustable rate mortgages, many of those rates are resetting to much higher interest rates (and, consequently, much higher monthly payments).

It’s true, as the NAR has been saying, that a home is the most substantial form of wealth that most Americans have.  And using the equity in our homes to get cash for other uses can be a fine idea.  But it’s not always.  Here, it’s borrower beware.

In a recent article in Realty Times, columnist Broderick Perkins wrote:

Home equity can be an emergency fund, investment pot, nest egg for retirement or a way to get out of more expensive debt.

Just keep in mind, when you use it, you lose it.

A home equity loan, by it's very nature, is an equity-depleting loan. You don't have an unlimited amount of equity to bank on.

The most conservative financial planners advise not fooling around with your home's equity. Eventually pay off your mortgage so that when you retire on a fixed income you'll be home free with no mortgage payment.

However, emergencies do arise and it's nice to know you've got something to fall back on, other than credit cards. That's particularly true as you age and your health wanes and during hard economic times that threaten your employment.

Again, the conservative advice suggests, instead of using your equity, even during an emergency, you should have socked away an emergency savings fund of from three to six months worth of your income as part of a sound financial plan.

Broadly speaking, there are five rules to follow if you’re considering taking out a loan against the equity in your home (including a home equity loan, home equity line of credit, or cash out refinance):

1.  Think about how much equity you’ll have left after the loan.  If you currently have 50% equity in your home and you take out 20%, then you still have 30% equity left, a pretty big chunk. That means that even if the market dropped 25% (much more than it has in most areas recently), you’d still have more equity than you owe on your mortgage.  If, on the other hand, you currently have 20% equity and are thinking about taking 15% of it out, you’ll only have 5% left to weather any market fluctuations – and that’s kind of a scary place to be in.

2.  Understand clearly the terms of your equity loan agreement.  If you’re doing a cash-out refinance, getting a fixed-rate mortgage is always safer than an adjustable rate mortgage.

3. Consider what you’ll gain, and lose, by taking the equity out of your home.  If you’re home is appreciating at a typical rate of about 6% a year, and you use the equity cash to pay off higher-interest debts that averaged 12% a year, then you’re better off (providing that you don’t end up owing more than your home is worth or facing rapidly rising payments with an adjustable rate mortgage).

4.  Consider your other options.  If you can get a personal loan instead of using your equity, that may be a better idea (again, depending on the kind of equity loan you get, how much equity you have to being with, and what the market’s like in your area).

5.  The safest bet is to consult a financial planner who specializes in advising people on these types of decisions.