Borrowing against your home might seem like an easy way to access cash when you need it -- but beware the pitfalls involved.
Image source: Getty Images.
There's a reason we're told to sock away three to six months' worth of living expenses in a savings account: That money could prove crucial when a financial emergency arises. But what if you don't have much in savings? You might resort to a personal loan or, worse yet, charge up a storm on a credit card and pay it off over time. But if you own a home, you might have another option: borrowing against its equity.
The term "home equity" refers to the portion of your home that you actually own. Most people who buy homes don't purchase them outright. Rather, they make a down payment and then borrow the rest of the money in the form of a mortgage. Your equity, therefore, is the difference between the market value of your home and the amount you owe on it.
To give you an example, imagine you buy a $300,000 home and put down 20%, or $60,000, and take out a $240,000 mortgage to cover the rest. If your home's value stays at $300,000, you'll have $60,000 in equity. If your home's value rises to $400,000 overnight before you've had a chance to pay down any of your mortgage (unlikely to happen, but we'll go with it for the sake of this example), you'll have $160,000 in equity.
One of the benefits of having equity in your home is that you can borrow money against it as the need arises. Here, we'll talk about the ways you can do so -- and what hazards you need to look out for.
Home equity loans
As the name implies, a home equity loan allows you to borrow money against the equity you've built in your property. With a home equity loan, you can borrow a lump sum of cash up front, and you'll then be responsible for repaying that loan over time. As is the case whenever you borrow money, you'll have an interest rate attached to that loan so that your lender gets some money out of the deal. The interest you accrue will therefore add to the cost of your loan; if you borrow $20,000 against your home equity, you'll wind up paying back more than $20,000.
The benefit of taking out a home equity loan is that it's generally easy to qualify for. The reason? Your home is being used as collateral against that loan, which is ample protection for your lender in the event you stop making payments. With a home equity loan, you might qualify for a larger sum of money than you would through a personal loan, as well as a lower interest rate. And because that rate is fixed, you know what you're signing up for.
You can use the money you borrow through a home equity loan for whatever purpose you'd like. Many people assume that home equity loans can only be used for expenses that are home-related, such as repairs or improvements. In reality, you can use a home equity loan to pay for college, a vacation, or whatever major expense looms in your life.
Keep in mind, however, that if you use your home equity loan for non-home-related expenses, you'll lose the option to deduct that loan's interest on your taxes. It used to be that you could deduct the interest paid on up to $100,000 in home equity debt, but the 2018 tax overhaul changed that rule. Now, you can only deduct home equity loan interest if that loan is used to improve your home -- say, by putting on an addition, finishing a basement, or replacing outdated plumbing and HVAC systems. The good news, however, is that the former $100,000 cap no longer exists. Now, you can deduct the interest on up to $750,000 in "qualified residence loans," which include both home equity loans and mortgages.
On the other hand, home equity loans have their drawbacks. First, as is the case with all loans, you'll be liable for closing costs, which will make borrowing even more expensive. More importantly, by taking out a home equity loan, you're technically putting your home at risk.
If you borrow against your home but fail to make your scheduled payments, you risk getting foreclosed on so that your lender can recoup its unpaid funds. That's a scary prospect, to say the least.
Another thing to keep in mind is that some home equity loans come with terms that might restrict you in other ways. For example, your home equity loan might prohibit you from renting out your property during your repayment period. As such, by borrowing that money, you might lose out on a stream of income.
Finally, home equity loans almost make it too easy to overborrow. Because they're a cinch to qualify for (provided your home equity actually exists) and have relatively favorable terms, you might be tempted to take out a bigger loan than you really need and spend that money on less-than-essential things, all the while racking up interest charges and, as mentioned above, putting your home at risk.
Home equity lines of credit
A home equity loan isn't the only way to borrow money against your home. You can also get yourself a home equity line of credit, or HELOC. As with a home equity loan, you can qualify for a HELOC based on the equity you've built in your property, and your property will serve as collateral for any amount you end up borrowing.Here's where home equity loans and HELOCs differ: With a home equity loan, you're borrowing a lump sum right off the bat. With a HELOC, you get a line of credit that you can draw on as you see fit.
Imagine you qualify for a home equity loan in the amount of $20,000. In that case, you're borrowing that $20,000 on day one, and you'll be on the hook for interest on that sum as soon as that loan agreement is complete. With a HELOC, you'll have the option to borrow up to $20,000 for a specified period of time. If you choose to take out $5,000 of that, you'll only be liable for interest on that $5,000. As such, HELOCs generally offer borrowers much more flexibility than home equity loans, which is one of their main benefits.
Another advantage of taking out a HELOC is that you'll generally snag a lower interest rate than you would for most types of loans, and some HELOCs come with low or no closing costs. Further, if you use your HELOC for home improvement purposes, you may be eligible to write off its interest, just as you could with a home equity loan used for the same reason.
Just like home equity loans, however, HELOCs can be dangerous, as they put you at risk of losing your home if you borrow money and can't repay your debt. Additionally, since you might qualify to borrow a large sum of cash, that risk is amplified if you max out your HELOC in a short period of time. Furthermore, your HELOC might restrict you from renting out your home, thereby removing a potential income source.
Another issue with HELOCs is that they typically come with adjustable interest rates. This means that rather than locking in a fixed interest cost, you're running the risk that your rate -- and thus your payments -- could rise over the life of your HELOC.
While some HELOCs come with low or no closing costs, others impose fees that could add to your borrowing expenses. You'll need to review the terms of your HELOC carefully to avoid getting caught in this particular trap.
Speaking of fees, some lenders charge an annual fee for the privilege of having a HELOC. Others charge prepayment penalties or cancellation fees if you close out your HELOC within a certain period of time after opening it. This could be a problem, for example, if you were to take out a HELOC and then decide to sell your home shortly thereafter.
Oh, and let's not discount the possibility of being charged an inactivity fee. That's the penalty your lender might hit you with if you decide not to take out money from your HELOC at all. Not all HELOCs have this feature, though.
Finally, your HELOC may not be guaranteed. Some HELOCs allow lenders to freeze or cancel your line of credit if your financial circumstances change (say, if you lose your job or take a pay cut) or if market conditions cause the value of your home to decline. As such, you might get yourself a HELOC thinking it'll be there as your safety net, only to find that when you actually need that money, it's no longer available to you.
The bottom line on borrowing against your home
Taking out a home equity loan or HELOC is a good way to access what could be a large amount of money without having to jump through a lot of hoops. It's certainly better than charging expenses on a credit card and paying exorbitant amounts of interest that not only cost you money, but drag down your credit score in the process.
That said, before you take out a home equity loan or a HELOC, make sure you know what you're getting into. Read the fine print on your loan or HELOC contract so you're not hit with any surprise costs or fees, and don't borrow more than you can reasonably afford to pay back.
Finally, realize that a home equity loan or HELOC shouldn't take the place of a true emergency fund. The beauty of having money in the bank is that it's yours to use when and how you want to, and if you withdraw from savings in a pinch, you're not on the hook for interest while you work to replenish your bank account. Just as importantly, you don't put your most valuable asset -- your home -- on the line in an effort to drum up some cash.
The Motley Fool owns and recommends MasterCard and Visa, and recommends American Express. We’re firm believers in the Golden Rule. If we wouldn’t recommend an offer to a close family member, we wouldn’t recommend it on The Ascent either. Our number one goal is helping people find the best offers to improve their finances. That is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.