1. Home equity basics. The term home equity sounds a little complex, but it's simply the difference between your home's market value and what you still owe on it. For example, a home that's worth $200,000 and has a $150,000 mortgage balance has $50,000 in equity.
The double-digit declines in real estate values in some parts of the country erased equity and made home equity loans tougher to come by. If you're a homeowner with a solid credit history and home equity, you may be able to use this equity as collateral to borrow money with two key benefits:
- Low rates. Home equity rates are usually much lower than what you'd pay for a credit card or other loans that don't require collateral.
- Tax breaks. Getting money back from Uncle Sam when you file your taxes lowers your bottom line borrowing cost even more, generally speaking, you can deduct interest on up to $100,000 of home equity debt ($50,000 for married couples filing separate returns).
- Home equity loans immediately advance you a single sum of money and usually require payments over a fixed period at a fixed interest rate.
- Home equity lines of credit give you the option of borrowing money as you need it, up to the amount your lender approves for you. Rates are variable, so your payments will fluctuate with changes in interest rates and will vary as your balance changes.
3. Use them wisely. Home equity interest rates are attractive to lenders because you pledge your family's shelter as collateral. If you bite off more than you can chew, you put your home at risk.
Your first consideration shouldn't be how much you borrow, but rather why need it. Debt is best used to improve your financial position or to purchase necessities with lasting value. That means you probably shouldn't use a home equity loan for clothing, vacations, gifts, gadgets and impulse purchases no matter how low your after-tax cost of borrowing.
Here are a few potentially wise uses of home equity debt:
- Debt consolidation. By consolidating multiple balances into a single home equity loan, you can simplify your life and potentially realize a dramatic reduction in your borrowing costs. But beware: Debt consolidation only works if you have discipline. If you run all your balances back up again, you'll be in worse shape than before.
- Home improvement. Before you upgrade your kitchen counters or expand your master bathroom, consider the long-term economic value of the project and how long you expect to remain in the home and enjoy the results yourself. Also keep in mind that many homeowners were burned when falling market values erased the value of their improvements.
- Covering college. Home equity can be an efficient way to borrow money for college, but make sure you've explored federally sponsored alternatives. As you do, remember that you may be able to deduct up to $2,500 in student loan interest, depending on your income. And while education is a sound investment in your child's future, make sure debt doesn't thwart your own drive for financial security or retirement.
