The expansion of prices in the housing market combined with record-low interest rates means that families across the country are growing their net worth simply by being homeowners. As of July 2021, housing prices have increased 18% year over year.1
As you pay down your mortgage, your home is essentially acting as forced savings. But how can you tap those “savings” to build your overall wealth or even diversify your assets? Tapping into your home equity can provide access to funds at very low interest rates, which can reduce your debt costs overall or be used to finance an outright wealth-building strategy, like a new business opportunity. However, this strategy comes with unique risks.
Home equity loans let you borrow against the equity in your home. We break down how home equity can be used as a wealth-building tool in the right situations.
Structures to Cash-In on Home Equity
Home equity loans generally allow a homeowner to borrow up to 80% of the home’s value. The homeowner can borrow a lump sum and then pay it back over time. Unless the home is mortgage-free, this would be considered a second mortgage as you would be paying the original mortgage in addition to the equity repayments.
A home equity line of credit (HELOC) is like a home equity loan in the sense that you’re adding an additional mortgage payment, but the main difference is that instead of getting all the borrowed cash upfront, you can borrow as needed. However, unlike home equity loans, HELOCs typically have adjustable interest rates. This generally means they make more sense in falling interest rate environments. However, since rates are historically low, the advantages may outweigh a potential rate increase.
For those who have experienced significant home appreciation, a cash-out refinance is another way to tap into the equity you’ve built up, as it can provide lower interest rates than both HELOCs and home equity loans. With a cash-out refinance, a homeowner refinances their home for more than the initial mortgage, allowing them to take out the difference in value.
The cash-out refinance strategy does have its downsides, as there are additional closing costs.
Using Equity to Build Wealth
Home equity is typically used for larger purchases or expenses that have clear potential upside. You are putting your home up as collateral, so it’s crucial that the funds are being used responsibly to potentially create more value.
Tapping into home equity really comes down to one thing: Can you earn more with the borrowed funds, even if it is over time than the cost of the loan? If so, using home equity can be an effective wealth-building tool.
Renovations and Additions
Doing renovations or building an addition onto the home are common uses of the funds. If you are doing a renovation to increase the home’s value before sale, you’ll need to be sure your plans meet potential purchaser taste requirements and are in an area – like a bathroom – that adds to the sale price. Also, for those who itemize their deductions, you may be able to deduct the interest paid if the funds are used to “buy, build, or substantially improve the taxpayer’s home that secures the loan”, according to the IRS.2 If you are planning to sell your home, a loan can raise your basis in the home, which can lower your capital gains taxes on the sale.
Paying off Debt
Paying off high-interest debt –– such as credit card debt or auto loans –– may be an effective use of home equity to save money. While this can be an effective strategy, using home equity to pay off credit card debt may only temporarily mask a spending problem. Since a home equity loan is generally riskier than other loans, failing to address the spending problem will only result in more headaches, a continuous cycle of debt management, and potential foreclosure.
Paying off student loans, or even using home equity to fund an additional degree, can make sense. Depending on your loans, you may be locked into a higher interest rate with a very long repayment timeline. Paying off student loans can potentially save quite a bit of money long-term, even if it temporarily increases your monthly payment amount.
Starting a Business
A strategy for an entrepreneurial risk-tolerant individual may be using the funds from a HELOC to start a business. This comes with considerably more risk than paying off debt or doing renovations, as there’s no clear upside when starting a business. You’ll need to have a business plan in place, with targets you need to meet before each drawdown of funds. This will help ensure you don’t get too far out on a funding limb without meaningful chances of success.
The Risks of Using Home Equity
While tapping into home equity can be a viable option to expand your wealth, it does come with considerable risks. First, your home is on the line. Even though the interest rates may be lower than those of credit cards and other debts, those debts don’t come with the risk that failing to repay a home equity loan does. In a worst-case scenario, if you cannot repay the loan, since the home is being used as collateral, the bank could decide to foreclose on it.
Also, depending on the type of loan, the interest rates may be variable. This means the homeowner may end up paying more over the length of the loan than they expected.
If thinking about using home equity, first determine how much makes sense for the situation. Have a plan for how the money will be used, understand the potential value created with the loan proceeds, and accurately gauge your ability to repay it.
If used appropriately, tapping into home equity can be an effective wealth-building strategy, but it does come with risks. Talking with a financial advisor can help run through the numbers and determine if it’s the right move for your situation.
1. Economy Team. U.S. Home Price Insights. September 7, 2021. CoreLogic.
2. Internal Revenue Service. Home Mortgage Interest Deduction. March 1, 2021. IRS.
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The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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