Equity is the difference between a home’s fair market value and the outstanding mortgage balance. When the housing market crashed in the fall of 2007 and into 2008, many homeowners across the nation lost much, if not all, of the equity in their homes.
Homeowners who do have equity in their homes have the option to borrow money against the equity they have built up with a loan or line of credit. In both cases, the house serves as collateral, which means the creditor may seize the home and sell it if the homeowner can no longer make the payments. Tapping into your home equity can be detrimental if you enter into the contract without fully understanding the repercussions.
While risky, there are some instances when a home equity loan makes good financial sense. To help you sort out the confusion, we’ve provided some common home equity do’s and don’ts:
DON’T use home equity to purchase unnecessary luxuries. 
Consumers shouldn’t use home equity for luxury items like a fancy car, boat, big screen TV or a vacation. The fleeting moments of joy aren’t worth putting your family’s security at risk.
DO use home equity for improvements or additions that add value to your home.
Ideally, it is an asset and should be used for other assets. A home equity loan can be effective if it’s used for home improvements that maintain or increase the resale value of the home. It may also be appropriate to use home equity to purchase income-producing property or an investment that’s expected to generate a higher return than the cost of the loan.
DON’T tap home equity if you plan to sell in the near future.
In order to sell your home, you need to pay off all debts related to your home. It could be a poor move to tap equity for improvements if you aren’t able to pay off the loan or line of credit prior to your desired sell date.
DO consider using it to cover expenses from unexpected events.
If you do not have emergency savings, the equity in your home can provide financial relief related to unexpected events, such as an injury preventing you from working. However, it’s ideal to have an emergency fund with at least three to six months of living expense. If you don’t have an emergency fund, we suggest you start making regular contributions now. Many consumers start with a $25 contribution each month, and then increase their contributions as their income allows it.
DON’T take out excessive equity.
If you decide to use your home equity, don’t take out more money than absolutely necessary. This will help eliminate the temptation to spend the funds on unnecessary luxuries. Also keep in mind that a home equity loan or line of credit decreases the amount of equity you have in your home. If you have taken out too much equity and the real estate market drops, you can end up losing all the equity in your home. Further, if you have negative equity, the lender may demand immediate payment of the loan.
DO consider tapping into it for use in retirement.
Retired homeowners who have paid off their mortgage can sell their home and cash out the equity by downsizing. Further, homeowners 62 and older have the option of reverse mortgages; the bank will give your equity back to you while you’re still living in it. The homeowner does not need to repay the mortgage for as long as he/she lives in that house. Learn more about reverse mortgages here.
FAQs
Never use your home equity line of credit to pay for basic expenses like clothing, groceries, utilities or insurance.
What is the disadvantage of using home equity? ›
Home Equity Loan Disadvantages
Higher Interest Rate Than a HELOC: Home equity loans tend to have a higher interest rate than home equity lines of credit, so you may pay more interest over the life of the loan. Your Home Will Be Used As Collateral: Failure to make on-time monthly payments will hurt your credit score.
Is it a good idea to take equity out of your house? ›
A home equity loan could be a good idea if you use the funds to make home improvements or consolidate debt with a lower interest rate. However, a home equity loan is a bad idea if it will overburden your finances or only serves to shift debt around.
Is it a good idea to use home equity to consolidate debt? ›
Using a home equity loan for debt consolidation will generally lower your monthly payments since you'll likely have a lower interest rate and a longer loan term. If you have a tight monthly budget, the money you save each month could be exactly what you need to get out of debt.
What is the best way to use a home equity loan? ›
Reasons to consider tapping into your home equity
- Funding a student loan for yourself or your child.
- Paying off or consolidating credit card debt.
- Funding a vacation.
- Paying for weddings or important celebrations.
- Starting a business.
- Making home improvements and upgrades.
- Paying medical bills.
The amount you can borrow is based on the equity in your home, and you can use the funds for any purpose. This option can be ideal if you have a specific large expense or debt to pay off. It also comes with the stability of predictable monthly payments.
Why is home equity risky? ›
The bottom line. Home equity loans and HELOCs come with the risk of losing your house if you miss multiple payments. During times of economic uncertainty, it's critical to make sure your monthly budget can handle fluctuations to your second mortgage payment if your payments increase.
What are the risks of using equity? ›
CONS
- Increased mortgage repayments. Accessing your property's equity increases the amount you owe on your mortgage. ...
- Taking on increased risk. If you are borrowing extra to invest, you need to consider how the risk is magnified. ...
- Excessive interest if not repaid quickly.
Equity is your home's market value minus your mortgage balance. Although it's sometimes called a second mortgage, a home equity loan doesn't affect your mortgage. Your mortgage interest rate, term and payments stay the same—you'll just have another monthly payment.
What happens when you take equity out of a property? ›
Taking out a loan on your home equity can provide funds for costs such as medical bills, college tuition, home improvements or other reasons. It also allows you to consolidate your debts at a lower interest rate, and the interest you pay may be tax-deductible if you use the funds to make improvements to your home.
What is a good amount of equity in a house? It's advisable to keep at least 20% of your equity in your home, as this is a requirement to access a range of refinancing options. 7 Borrowers generally must have at least 20% equity in their homes to be eligible for a cash-out refinance or loan, for example.
Why you're better off not borrowing? ›
Studies show that such debt is correlated with stress. The size of the debt also matters: Unhappiness and burnout are higher when student loans are larger. Again, this is very likely because carrying the debt inhibits the satisfaction of making progress toward financial freedom and security.
Is it smart to use equity to pay off debt? ›
If you are able to afford only a fixed amount every month to pay off debt, taking out a home equity loan to pay down your loan balances can help you settle debt more quickly. A lower interest rate means that a greater portion of your monthly payment each month goes toward paying down the principal.
Does a home equity loan hurt your credit score? ›
When you take out a loan, such as a home equity loan, it shows up as a new credit account on your credit report. New credit affects 10% of your FICO credit score, and a new loan can cause your score to decrease. 4 However, your score can recover over time as the loan ages.
Can I use my home equity to pay off credit cards? ›
A home equity loan can be an excellent option to zero out credit card debt, but the decision to get one should be taken with great care. If your income is inconsistent or your long-term job outlook is unclear, a home equity loan could be risky, especially considering your home is on the line.
What are the pros and cons of pulling equity from your home? ›
By: Amy Fontinelle
- Pros.
- ● Lower monthly payments.
- ● Proceeds that can be used for any purpose.
- Cons.
- ● Your home secures the loan, so your home is at risk.
- ● You have to borrow a lump sum.
- ● You can't get a home equity loan with too much debt or poor credit.
- Pro #1: Home equity loans have low, fixed interest rates.
A home equity loan works well if you have a big ownership stake and need a large, fixed lump sum. A cash-out refinance may be the smarter option if you want a lower interest rate and to deal with just one big debt.
What is the risk of using the equity in your home as collateral? ›
Keep in mind the risks involved when using your home as collateral. If you can't pay the money back, you could lose your home to foreclosure. Talk to an attorney, financial advisor, or someone else you trust before you make any decisions.
How can I take advantage of home equity without selling? ›
A cash-out refinance allows you refinance your current mortgage for more than the outstanding balance and take the difference in cash. A cash-out refinance replaces your existing mortgage, so depending on market conditions, you might be able to get a lower rate or better terms with the new loan.
