Equity represents the difference between the current market value of your home and the amount you owe on your mortgage, and it can be a valuable asset to access cash when you need it. Tapping equity may be a particularly enticing option for homeowners who are flush with home equity after home values soared in recent years. According to the Federal Reserve Bank of St. Louis, the median home price has skyrocketed from $327,000 just before the pandemic to a median price of $436,800 in the first quarter of 2023.
However, tapping into your home equity isn't always a good idea, such as when interest rates are high or when you plan to use proceeds to pay for a vacation or other optional expense. Remember, 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 mortgage payments. As such, it's crucial to proceed cautiously when considering using your home equity. Here are six reasons not to access your home equity.
1. Interest Rates Are High
Currently, we're experiencing a period of high interest rates as the Federal Reserve has increased rates 10 times since March 2022 in an effort to curb inflation. When the Fed hikes interest rates, interest rates on home equity products also tend to rise.
Even in times of low interest, interest rates on home equity loans, HELOCs and cash-out refinances are typically higher than primary mortgage loans. And most HELOCs—and certain types of mortgages—come with variable interest rates, which means you won't be protected from future hikes even if you borrow them when interest rates are low. If rates rise significantly from when you refinance or access your home equity, making your payments could become more challenging.
Rates on loans and lines of credit can be even higher if your credit score is less than ideal. For these reasons, it may make sense to hold off on a home equity credit product until you're able to improve your credit or the Fed begins to lower rates (or both).
2. You Want to Go on Vacation or Pay a Large Optional Expense
As a general rule, the best-case scenario for taking on debt is if it can help you grow your wealth or otherwise improve your financial position. For example, a mortgage can help you buy a home that may appreciate in value over time, and a student loan can help you get an education that improves your long-term earning potential.
As such, borrowing money for a significant expense 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. You Want Use Home Equity to Pay 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. You don't have to pay back federal grants and scholarships, and federal student loans generally come with lower interest rates than home equity financing, flexible repayment plans and potential student loan forgiveness.
Home equity loans and HELOCs historically have lower interest rates than private student loans. However, their rates have been closing the gap, and the advantage of lower interest rates might not be as significant as before.
Bear in mind, failing to make payments on a home equity loan or line of credit exposes you to the risk of foreclosure. Given the risks, tapping your home equity to pay for school may not make sense.
4. You Want Use Home Equity to Invest
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 for you when rates are low and property values are rising, but it's no guarantee. As we saw during the housing crisis in the mid-2000s, when home prices crash, you can become financially trapped in a home in which you owe more on the mortgage than the house is worth.
Similarly, using your home equity to invest in the stock market isn't a surefire strategy. Even for experienced investors, the stock market can be highly unpredictable. If your investments take a hit, you could lose the home equity you've invested and still be saddled with the debt.
5. You Plan to Buy a Car With Home Equity Proceeds
In recent years, home equity loans and HELOCs offered much lower interest rates than car loans. But according to the most recent Federal Reserve data, the average interest rate on a five-year auto loan is 7.48%, which is very similar to interest rates on home equity loans and HELOCs.
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, even though the interest rates may seem similar at first glance.
Remember, cars depreciate quickly, with most vehicles losing roughly 20% of their value within the first year. If you take out a long-term home equity product to buy your car, 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 dedicated high-yield savings account to set aside 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. Help to safeguard your relationship by setting up a written contract that outlines the loan amount and repayment schedule and then honor your agreement.
- Direct unexpected windfalls toward savings. Whenever you receive unexpected money, like tax refunds, work bonuses or an inheritance, allocate some or all of it 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. With introductory periods lasting as long as 21 months, you'd have a considerable window to reduce your debt without interest charges and without risking your home.
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. It's not only where you live, but it might be your biggest financial asset. 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 for free with Experian to get an idea of your current credit status. Consider taking steps to improve your credit before applying for a new loan.