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If you own your own home, you may think of it as more than just a place to live. For many, their home is their most valuable asset, and something they may think of as a giant piggy bank to be tapped when times get tough.
Using home equity is a serious decision, however. You have to know when it makes sense, and if it does, how to tap into those funds in just the right way. Here is what you need to know about using your home's equity when you're experiencing a financial emergency.
How You Can Access Your Home's Equity
Home equity is the estimated market value of your home minus the balance remaining on your mortgage. So if the current market value of your home is $350,000 and you still owe $250,000 on the loan, you have $100,000 in equity ($350,000 - $250,000).
You build equity in two ways. First is by making your mortgage payments, which decreases your remaining loan balance month by month. The second way is when your home increases in value due to changing market forces. You may have bought your home 10 years ago when it was valued at $350,000, but today it would sell for $400,000. That additional $50,000 is added to your equity.
Of course, that money isn't in your bank account—it's attached to the property until you take action. There are a number of ways to extract those funds. When a crisis hits, using one of these available methods to do so can spare you from disaster.
Home Equity Loan
A home equity loan is a second loan on your home, separate from your original mortgage. With a home equity loan, most lenders will let you borrow between 75% and 85% of your available equity. Therefore, if you have $100,000 in equity, $75,000 to $85,000 may be available to you. If you need a huge sum all at once, home equity loans can be a lifesaver.
To qualify for a home equity loan with a low interest rate, you'll likely need to have a credit score in the mid-600s or better and at least 20% equity. Your debt-to-income ratio (monthly debts divided by your gross income) should be no more than 43%, though some lenders will allow up to 50%.
You repay a home equity loan in even monthly installments, with a repayment term usually ranging from five to 30 years. Just as your first mortgage is secured by the property, so is the home equity loan, meaning you can lose your home if you fall behind on your payments.
Although home equity loans may give you access to a large amount of capital, there are some downsides to consider. For instance, you will pay plenty of fees to acquire the loan. Closing costs alone will run you 2% to 5% of the loan amount, so if the loan is $75,000, that could cost you as much as $3,750. You'll also deplete your home's equity and have monthly payments to make. If your home's value drops, you could end up owing more than the home is worth, which will be problematic if you need to sell it. Finally, home equity loans tend to charge more interest than cash-out refinance loans.
That said, if you know you can afford to make the monthly payments, home equity loans can be very helpful when you're facing a financial emergency.
A cash-out refinance replaces your original mortgage with a new loan that lets you tap into your home equity. Your new loan will be higher than what you owed on your previous mortgage, and you'll get the difference (minus closing costs and fees) in cash. This option could allow you to refinance your mortgage at a lower interest rate. You can then use that money to cover a financial emergency.
To be eligible for a cash-out refinance, you'll need to meet the lender's qualification requirements and have accumulated some equity in your home—but you'll also be able to take advantage of increased equity due to a rise in your home's value. In general, you can only take about 80% of your home equity, though FHA loans and VA loans allow you to take more.
The balance on the new mortgage will be more than the previous balance because the amount of equity you cash out will be added to it, as will any associated costs. In fact, the fees on cash-out refinances can be daunting. For example, if you refinanced to a $350,000 loan and the closing costs are calculated at 5%, another $17,500 would be added to the debt.
Home Equity Line of Credit
Instead of withdrawing a lump sum from your home's equity, you can also draw from it with a home equity line of credit, or HELOC. If you need a steady stream of money for emergencies, HELOCs can be an attractive solution.
Here's how they work: A lender will assess the amount of equity in your home, your financial circumstances and your credit rating. Depending on those factors, the lender will then assign a limit to your new line of credit as well its interest rate and how long you can draw from it (draw period). For example, you may qualify for an $70,000 HELOC at 5% interest that you can tap into for 10 years.
To extract the money, you can use a bank-provided card to make purchases like you would with a traditional credit card, though you can also write a check, withdraw funds from a branch or ATM, or electronically transfer the money into your savings or checking account.
As with a credit card, you will need to make at least the minimum payments, which are calculated based on your balance and interest rate. If you still have a balance after the draw period ends, a repayment period, often 20 years, begins. Some lenders offer HELOCs with no closing fees, as long as you keep the loan open for a set period of time.
There are a few HELOC downsides to consider. Like a home equity loan, a HELOC depletes your equity and can put your home in jeopardy of foreclosure if you fail to pay. Easy access to the line can cause you to overuse it. And since interest rates are variable, the debt may be more expensive than you expect if rates rise. If you only pay the minimum each month, the payments will probably be larger when you still have a balance and the draw period ends.
If you're 62 or older, a reverse mortgage is yet another way to access your home's equity. Reverse mortgages allow you to convert some of the equity in your home into cash. You get to stay in your home, and instead of making payments, you would receive them instead.
To be eligible, you need to have at least 50% equity in the home. There is no minimum credit score requirement, though the lender will want to be sure you can handle the ongoing expenses required to maintain the home, and will check to see if you've paid your housing and other debts on time.
You don't have to pay the loan back as long as you reside in the property. Reverse mortgages erode the equity and increase the size of the loan, so when you pass the home to your heirs, they will be responsible for the payments. A number of fees are involved with reverse mortgages, and most come with variable rates.
Reverse mortgages are not a good idea if you think you may have to move in the future, because if you do, the loan must be repaid in full. You also must be able to afford the costs associated with the home, such as property taxes, insurance premiums and home maintenance. If you fall behind, the lender may call the reverse mortgage due, and that can cause you to lose your home.
How Using Home Equity Affects Your Credit
Before pursuing home equity options, check your credit report and scores. Lenders will refer to them to determine qualification and to set terms. You'll want to pursue only those credit products that are within reach and will be to your benefit.
Home equity loans and cash-out refinance loans appear as installment loans on your credit reports. HELOCs are listed as a revolving line of credit, similar to a credit card. All of these credit types can enhance your credit rating if you manage them responsibly. Miss payments, however, and your credit rating can decline. Go into default or foreclosure, and your credit will suffer and you can lose your home.
Because you don't make payments on a reverse mortgage, most lenders don't report that loan to the credit reporting agencies.
When Should You Tap Your Home's Equity?
Using your home's equity is a serious decision. When you're doing it to cover an emergency, make sure it's for something that you truly need. Reasons might include:
- Uncovered medical or dental costs: If your medical insurance policy has a high deductible, you could be saddled with massive bills. Dental bills, too, can accumulate to an amount that's more than you can afford to pay with income or normal savings.
- Necessary home repairs: Termites, blown water heaters, faulty electrical work—these all can be very expensive and yet necessary to fix.
- Car repair or replacement: Tapping your home equity might cost more than it's worth for a car repair (a 0% APR credit card or personal loan may be a better option), but it could be worth considering depending on your situation.
- Legal expenses: Maybe you're in the middle of a drawn-out divorce, have been sued or are involved in a criminal investigation. Lawyers aren't cheap, so the equity in your home can come in handy.
- Big tax bill: Owing the IRS or the state can be pricey, since penalty fees and interest are added in. Paying off tax debt in one fell swoop can save you a substantial amount of money.
- High interest debt: Although not technically an emergency, when you're overwhelmed by debt and are paying high interest rates, using home equity could make sense—as long as you're not tempted to run up your cards again once they are paid off.
- Job loss: Unemployment is a possible reason you may want to reach into your home's equity. Just make sure you'll be back to work soon so you can make any necessary loan payments—otherwise you put your home in danger.
When Should You Avoid Using Home Equity?
Not every uncomfortable financial scenario is an emergency. Here are some examples of when you should reconsider pursuing any of the home equity draining options:
- You can wait. Ask yourself if you can delay the purchase or the bill. If you can, save for what you need instead.
- The thing you want isn't that important. Vacations, cellphone upgrades, holiday gifts and the like are wonderful, but are not worth tapping your home's equity for.
- It puts your home at risk. It is crucial that you assess the feasibility of new payments. If you can't make them easily, and over the long term, stop.
- The fees are too high. If your credit scores are on the low side, a prohibitive interest rate or fees could do more harm than good.
Other Ways to Find Cash in a Financial Emergency
Before turning to your home to finance a financial emergency, explore all alternatives. Review your budget carefully. If you can pare down your expenses to the most basic for a period of time that enables you to pay for the emergency expense, do it. It will prevent you from using your precious equity, which you may want to utilize later for another purpose or simply keep accumulating.
Also explore ways to increase your income. If you can earn enough money quickly, you won't have to borrow from your home or reduce an already trim budget. Look into getting a second or part-time job. Or maybe you have electronics, sports equipment, a second car or valuable jewelry that you can sell and use for the emergency expense.
A credit card, too, can be preferable to tapping home equity. As long as you pay the debt off quickly, the financing fees shouldn't be too high. A $5,000 charge with a 19% APR (annual percentage rate) and payments of $670 will take you eight months to pay and cost $362 in interest. Even better is a new credit card with a promotional rate of 0% APR for six months or longer. If you pay it off within that time frame, it's a free loan.
If creditors are breathing down your neck and that's your financial emergency, take heart. Many issuers are willing to offer concessions to valued good cardholders, especially if they reach out before the payment's due date. Try to work out a hardship plan where you suspend payments for a few months instead. Trading unsecured credit card bills or collection accounts for a liability that is secured by your home could leave you without a place to live.
It's always a wise idea to carefully weigh whether you truly need something before you spend the money, but it's essential when considering using your home's equity. Don't take a hammer to this particular piggy bank unless you're sure it's worth the risk and costs.