Soaring real estate values mean many homeowners are inundated with equity – the difference between what they owe and what their homes are worth. The average price of a home has risen 42% since the start of the pandemic, and the average homeowner with a mortgage can now leverage more than $207,000 in equity, according to Black Knight Inc., a market analytics firm. mortgage and real estate data.
Spending this wealth can be tempting. Product of home equity loans or lines of credit can fund home renovations, college tuition, debt consolidation, new cars, vacations – whatever the borrower wants.
But just because something can be done doesn’t mean it should be done. One risk of such a loan should be fairly obvious: you are putting your home at risk. If you can’t make the payments, the lender could foreclose and force you out of your home.
Moreover, as we learned during the Great Recession of 2008-2009, housing prices can go down as well as up. According to a 2011 report by CoreLogic, a 2011 report by CoreLogic, borrowers who tapped into their home equity were more likely to be “under water” — or owe more on their home than they did. were worth – than those without home equity loans or lines of credit. real estate data company.
Other risks are less obvious but worth considering.
Also see: Yes, it could happen to you. Like the water crisis in Jackson, Mississippi, other US cities are vulnerable to climate change catastrophe
You might need your capital later
Many Americans are not save enough for retirement and may need to use the equity in their property to avoid a sharp drop in their standard of living. Some will do this by selling their home 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 age 62 and older to convert the equity in their home into a sum of money, a series of monthly payments, or a line of credit that they can use as needed. The borrower does not have to repay the loan while living 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 a lot more income
Another potential use of home equity is to pay for a retirement home or other long-term care. A semi-private room in a nursing home costs an average of $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 plan instead to borrow against their home equity to pay those bills.
Obviously, the more you owe on your home, the less equity you will have for other uses. In fact, a large mortgage could prevent you from getting a reverse mortgage. To qualify, you must either own your home or have substantial equity – at least 50% and possibly more.
Lily: My wife and I have $750,000 in savings and earn over $144,000 a year. Can we afford to spend $5,000 a month on housing?
You are deeply in debt
Use the equity in your home to pay off a much higher rate debt, like credit cards, may 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 declaring bankruptcy, your unsecured debts, such as credit cards, personal loans, and medical bills, will usually be wiped out. Debts secured by your home, such as mortgages and home equity loans, are generally not.
Before using the equity in your home to consolidate other debts, consider speaking with a nonprofit credit counseling agency and a bankruptcy attorney to learn about your options.
Lily: Housing market ‘weakens sharply’ since peak in April, led by Seattle, San Francisco and San Diego
What you buy won’t survive the debt
It’s rarely, if ever, a good idea to borrow money for pure consumption, like 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 will result in higher incomes for life.
If you’re considering borrowing your home’s equity to pay for something that won’t increase in value, at least make sure you’re not making payments long after its useful life is over. If you’re using the equity in your home to buy a vehicle, consider limiting the loan term to five years so you don’t have to deal with large repair bills while paying off the loan.
Home equity loans typically have fixed interest rates and a fixed repayment term ranging from five to 30 years. The typical home equity line of credit, on the other hand, has variable rates and a 30-year term: a 10-year “draw” period, during which you can borrow money, followed by a 20 year repayment. You’re usually only required to pay interest on your debt during the drawdown period, which means your payments could increase significantly after 10 years when you start paying down the principal.
This brings us to one final piece of advice: with interest rates on the rise, only consider using a home equity loan or line of credit if you can pay off the balance fairly quickly. If you need a few years to pay off what you borrow, getting a fixed interest rate with a home equity loan may be the best way to tap into the equity now.
More from NerdWallet
Liz Weston, CFP® writes for NerdWallet. Email: [email protected] Twitter: @lizweston.