This article is reprinted by permission from NerdWallet.
Soaring real estate values mean many homeowners are awash in equity — the difference between what they owe and what their homes are worth. The average-priced home is up 42% since the start of the pandemic, and the average homeowner with a mortgage can now tap over $207,000 in equity, according to Black Knight Inc., a mortgage and real estate data analysis company.
Spending that wealth can be tempting. Proceeds from home equity loans or lines of credit can fund home improvements, college tuition, debt consolidation, new cars, vacations — whatever the borrower wants.
But just because something can be done, of course, doesn’t mean it should be done. One risk of such borrowing should be pretty obvious: You’re putting your home at risk. If you can’t make the payments, the lender could foreclose and force you out of your house.
Also, as we learned during the Great Recession of 2008-2009, housing prices can go down as well as up. Borrowers who tapped their home equity were more likely to be “underwater” — or owe more on their houses than they were worth — than those who didn’t have home equity loans or lines of credit, according to a 2011 report by CoreLogic, a real estate data company.
Other risks are less obvious but worth considering.
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You may need your equity later
Many Americans aren’t saving enough for retirement and may need to use their home equity to avoid a sharp drop in their standard of living. Some will do that by selling their homes and downsizing, freeing up money to invest or supplement other retirement income.
Other retirees may turn to reverse mortgages. The most common type of reverse mortgage allows homeowners 62 and up to convert home equity into a lump of cash, a series of monthly payments or a line of credit they can use as needed. The borrower doesn’t have to pay the loan back as long as they live in the home, but the balance must be repaid when the borrower dies, sells or moves out.
See: This new type of reverse mortgage would help retirees generate much more income
Another potential use for home equity is to pay for a nursing home or other long-term care. A semi-private room in a nursing home cost a median $7,908 per month in 2021, according to Genworth, which provides long-term care insurance. Some people who don’t have long-term care insurance instead plan to borrow against their home equity to pay those bills.
Clearly, the more you owe on your home, the less equity you’ll have for other uses. In fact, a big mortgage could preclude you from getting a reverse mortgage at all. To qualify, you either need to own your home outright or have a substantial amount of equity — at least 50% and perhaps more.
Read: My wife and I have $750,000 in savings and earn over $144,000 a year. Can we afford to spend $5,000 per month on housing?
You’re deeply in debt
Using your home equity to pay off much higher-rate debt, such as credit cards, can seem like a smart move. After all, home equity loans and lines of credit tend to have much lower interest rates.
If you end up filing for bankruptcy, though, your unsecured debts — such as credit cards, personal loans and medical bills — typically would be erased. Debt that’s secured by your home, such as mortgage and home equity borrowing, typically isn’t.
Before you use home equity to consolidate other debts, consider talking to a nonprofit credit counseling agency and to a bankruptcy attorney about your options.
Read: Housing market ‘weakening sharply’ from April’s peak, led by Seattle, San Francisco and San Diego
What you’re buying won’t outlive the debt
It’s rarely, if ever, a good idea to borrow money for pure consumption, such as vacations or electronics. Ideally, we should only borrow money for purchases that will increase our wealth: a mortgage to buy a home that will appreciate, for example, or a student loan that results in higher lifetime earnings.
If you’re planning to borrow home equity to pay for something that won’t increase in value, at least ensure that you aren’t making payments long after its useful life is over. If you’re using home equity to buy a vehicle, consider limiting the loan term to five years so that you’re not facing big repair bills while still paying down the loan.
Home equity loans typically have fixed interest rates and a fixed repayment term of anywhere from five to 30 years. The typical home equity line of credit, meanwhile, has variable rates and a 30-year term: a 10-year “draw” period, where you can borrow money, followed by a 20-year payback period. You typically are required to pay only interest on your debt during the draw period, which means your payments could jump substantially at the 10-year mark when you start repaying the principal.
This leads to a final piece of advice: With interest rates on the rise, consider using a home equity loan or line of credit only if you can repay the balance fairly quickly. If you need a few years to pay back what you borrow, getting a fixed interest rate with a home equity loan may be the better way to tap equity now.
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Liz Weston, CFP® writes for NerdWallet. Email: firstname.lastname@example.org. Twitter: @lizweston.