Are There Smart Ways To Use Home Equity?

One of the best things about home ownership is the financial options home equity provides. But many ask: how can you use home equity responsibly? So this month, I wanted to discuss couple different ways to access and use home equity – as a review to some and also as a primer for those gaining equity or those considering a home purchase.

There are two primary ways to access home equity to make investments or pay debts. Traditional home equity loans allow access to equity by refinancing your first mortgage or taking out a fixed-rate 2nd mortgage. You take your desired “cash out” when you do one of these loans. Your cash out comes in a lump sum, and you immediately start paying interest on that money even if you just put it in a checking account for use later. The other way to access equity is through a home equity line of credit (HELOC), which is a 2nd mortgage where you get a line of credit for a set amount, but you only draw funds as you need to. This is the cheaper and more flexible option because you’re only paying interest on what you use, and not until you use it. Below are a couple examples of ways to use home equity and what happens when you do.

Example 1: Buying a car. Right now car loans average about 3% whereas home equity loans average more like 6%. But consider these scenarios based on a $30,000 car purchase: A 3% car loan is usually amortized over 5 years, giving you a payment of $539 and no tax benefit. If you used a 7% traditional home equity loan to buy the car, your payment would be $199, of which $175 is tax deductible. If you used a 5% HELOC to buy the car, your payment would be as low as $125, all of which is tax deductible. This principle also applies to credit cards. It pays to convert that debt to gain tax benefit and lower your payments.

Example 2: Buying an investment property. First you must qualify for the monthly costs of another home (on top of your current home); this is easier than people think because rental income counts towards offsetting your monthly cost. But where do you get the down payment? From your existing home equity. So, let’s say you’re looking for a $400,000 rental property. You put an $80,000 HELOC in place on your existing home, and then start looking for the right investment property. When you’re ready to write an offer, you’ve already got up to 20% ready for a down payment. And remember, you don’t pay any interest on that $80,000 until you actually use it.

Of course, all the strategies are always predicated on your ability to qualify. Your debt-to-income ratio must be able to support the new amount of cash-out you elect to take. Not everyone will be able to do this, but for those whose ratios show they can afford it, sometimes employing equity in other ways is the best thing to do. Because of tax benefits. And also because home equity has no rate of return. So if you can take that equity and employ it in another area where it can earn a rate of return (such as an investment property or certain investment vehicles like municipal bonds which have safety of principal invested), it’s worth exploring.