The house you own is more than a place to live. It can also serve as a source of cash.
When financial emergencies arise, getting access to cash can serve as a temporary lifeline. But if your savings are low and you don’t want to run up debt on high-interest credit cards, tapping the equity in your home is an option to consider.
If your home is worth more than you owe on your mortgage, you have positive equity in your home. After eight straight years of median price gains for single-family homes, there’s a good chance you’re one of the 45 million borrowers with equity in their homes at the end of 2019, according to Black Knight, a real estate data analytics company. The average equity held by those mortgage holders is $119,000. Overall, there’s $6.2 billion in so-called “tappable” equity, according to Black Knight.
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Using your home as a piggy bank to pay for non-essential purchases is ill-advised, of course. But tapping the equity in your home via a home equity line of credit (HELOC), for example, during an emergency is a more responsible personal finance strategy.
“Theoretically, home equity can be used as an emergency fund,” says Daniel Milan, financial adviser and managing partner at Cornerstone Financial Services. But there’s a caveat: “Using a HELOC as an emergency fund should be a last resort.”
Audrey Blanke, a financial planner at Baird, views home equity as a “backup” to a traditional emergency fund, which typically covers three to six months of living expenses.
When a lender funds a home equity loan, HELOC or cash-out refinance, it uses your home as collateral. The good news is you’ll get a lower interest rate than you would on a credit card. The risk, however, is if you end up defaulting on the loan, you’ll lose your home.
A home equity loan pays you a lump sum that you pay back at a fixed rate every month. A HELOC, which charges a variable interest rate, works like a credit card, giving you the flexibility to access funds when needed. A cash-out refi is when you take out a new mortgage for a higher amount than you owed on your previous loan and use the extra cash to fund expenses.
Low rates, rising home prices boost equity
Right now, there are two reasons why using home equity to fund emergencies could make sense.
First, interest rates are at historic lows. “That makes it cheaper to borrow money, and for a lot of people their home is their greatest asset,” says Blanke.
The current average interest rate on HELOCs is 5.92%, versus 16.89% for credit cards, according to Bankrate.com. “Home equity has a significantly lower interest rate than credit cards, so it is much more prudent to use for emergency cash,” Milan says.
Second, home prices have been rising for many years. The median existing-home price for all housing types in February was $270,100, up 8% from a year earlier, according to the National Association of Realtors (NAR). February’s price increase marks 96 straight months of year-over-year gains, NAR says.
“We’re currently experiencing a rare combination of historically low interest rates and record-high available equity in homes,” says Jon Giles, senior VP and head of home equity lending at TD Bank. “This presents an opportunity for homeowners who may have built up equity in their properties and are seeking an affordable way to borrow.”
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Type of home equity to tap
The method you choose depends on the types of expenses you need to cover, says Blanke. A HELOC, she says, provides flexibility and lower costs upfront. You can tap HELOC funds when you need them via a debit card or check and then you pay interest only on what you spend during the draw period, which is normally 10 years. If you already have a line of credit open, this use of home equity is likely best as you won’t have to apply for a new loan and pay closing costs and other fees.
A home equity loan, which supplies you with a lump sum, is best-suited if you run into a one-time big bill, such as an unexpected major home repair, she adds. One plus of a home equity loan is you will know what you owe each month as the loan’s rate and term length are fixed.
A cash-out refi is another option, but make sure you don’t borrow so much against your house that your loan-to-value ratio drops below 80%. The reason? “You might end up paying monthly mortgage insurance,” says Blanke.
For homeowners who haven’t recently refinanced and have a rate much higher than current rates, Giles says a cash-out refi “may be advantageous as it would enable the borrower to combine everything into one low rate and payment.”
Keep in mind that the IRS will only let you deduct the interest on home equity loans if the loan interest paid was to “buy, build or substantially improve the taxpayer’s home that secures the loan.”
When not to tap home equity
Factor in the costs, says Blanke. If you need to apply for a HELOC or home equity loan, make sure you can afford the closing costs. Most importantly, make sure you can afford the added monthly payment.
“If your loan payments are more than your cash flow now or in the future, then you absolutely should not consider accessing your home equity,” Blanke says.
Bottom-line: “If a homeowner finds themselves in a financially stressed position, they need to ensure they can comfortably handle the debt before using their home as collateral through a home-equity loan product,” says Giles.