Home values are up. Way up. According to the real estate website Zillow.com, the average home’s value has shot up 6.8 percent in just the last year. That may not sound like a lot, but if you had a house worth $300,000 last year, if it’s as high as the national average, it’s now worth more than $320,000. That’s a serious chunk of change.
Naturally, a lot of banks are advertising home equity lines of credit, or HELOCs, and suggesting you use the additional funds to upgrade a kitchen or bathroom or pay for your kids’ college. Should you? As with so many situations, the answer is: It depends. But there are some questions you should ask yourself if you are considering it.
Would a home equity loan or refinancing be a better option? These days, probably not. Just to review, a HELOC is like using your home as a credit card. You might have a home equity line of credit for $30,000, for instance, but only actually borrow $10,000 or $5,000.
A home equity loan is for a specified amount of money. If you take out a home equity loan for $30,000, you get $30,000 in cash, pulled from the equity in your home – and then, of course, you have to pay it back in monthly payments like any loan.
Refinancing, as you likely know, is when you change the terms of your home loan. Generally, this is done when you want to lower your monthly payments. Some consumers apply for a cash-out refinance. Maybe you owe $100,000 on your house and want $30,000 to go back to graduate school. Ideally, you’d get smaller monthly payments (but not necessarily), and you would receive $30,000 in cash from your equity.
That can have its downsides, points out Mike Kinane, head of U.S. Home Equity Products for TD Bank, which is headquartered in Cherry Hill, New Jersey.
“Mortgage lenders will typically charge a higher rate for taking cash out – generally one-eighth to three-eighths of a percentage higher than the prevailing mortgage rate, in addition to passing the appraisal, title and closing costs to the borrower,” Kinane says.
He adds that because mortgage rates have been pretty low for the past five years or so, odds are, you’ve already refinanced or purchased your home at a low rate, and you may not be able to do much better than you already have. For most homeowners, Kinane says, there is a pretty good chance that the math will work out better if you get a HELOC.
Do I have a specific plan for paying back what I borrow? That wouldn’t be such a bad idea.
“Just before the Great Recession, many people were treating the equity in their homes as free money. These loans aren’t meant to be used frivolously, unless the borrower can afford to do so,” says Chris Diaz, who is based out of Orange County, California, and is vice president of HomeUnion Lending.
He adds: “Usually, there is a 10-year, interest-only draw period, followed by a conversion to a fully amortized 20-year adjustable rate. Depending on the size of the loan, that payment adjustment can range in the thousands of dollars. Depending on how one handles their finances, these types of loans can build wealth or a become a debt burden.”
All of this means that you do want to be careful about what you use the line of credit for. If you actually do use it like a credit card and pay off what you borrow every month or so, and you owe nothing after 10 years, then it was probably a good idea. If you use the loan to buy a car, and you still owe money on the loan after 10 years, then it probably wasn’t a good idea, says Casey Fleming, a San Francisco-based mortgage advisor and author of the book, “The Loan Guide: How to Get the Best Possible Mortgage.”
“Buying a car with your HELOC gives you a lower payment, and it may be tax-deductible, but your car will be used up in 10 years, and if you’ve made interest-only payments, you still owe the full amount,” Fleming says.
But Fleming says it makes more sense to finance long-term home improvements, like that kitchen upgrade. Unlike the car, the kitchen isn’t going anywhere.
Do I want to take out a HELOC to get rid of my massive credit card debt? You might. Many personal finance experts will tell you that it is smart to use a HELOC to pay off credit card debt, because a HELOC is going to have a lower interest rate than credit cards. (The average $30,000 HELOC is currently 5.45 percent, according to Bankrate.com; the average credit card interest rate is currently 16.69 percent.)
But that does you little good if you use a HELOC to pay off your credit cards, and then you just run those cards back up again, says Glenn Phillips, CEO of Lake Homes Realty in Pelham, Alabama.
“Then the home equity loan is just a big hole they may never dig out of without bankruptcy. This is a common trap of those who may mean well but lack the self-discipline to manage money. This will eventually cost them thousands and thousands of dollars they did not plan to spend and for which they derive no value,” Phillips warns.
It would be especially terrible if you run the credit cards up – and you don’t manage to pay off the line of credit before that payment adjustment.
Which isn’t to say that Phillips is against HELOCs. He just says, “Regardless of the market conditions, homeowners need to have very specific, smart ideas of why they are taking such a loan.”
As Phillips says, “This is a great time for a home equity line for the right people, and an awful idea for others.”
The challenge, of course, is to know if you’re one of the right people – or one of the others.