An article by BudgetQueen
You have owned your house for five years. Five years you haven’t missed a payment. You are one smart home owner!
Your house also has increased in value quite a bit. You wonder if you can get a loan on this “equity” or the amount that your house is worth minus the amount you owe. The interest rate on this loan is really low right now and you are wondering if you could use it to pay off a few things like credit cards, or add an addition, or just to add a security net.
I have experimented a time or two with home equity lines of credit. I know that in certain situations it is good to have, and in others it can be just as dangerous – if not a lot worse – than a credit card.
A home equity line of credit (or “second mortgage”) is essentially a loan against your home. You bought a house for $100,000 and it is now worth $125,000. Banks may give you a loan on this amount knowing that you have at least one asset that could cover the original loan (your mortgage) and the second loan (home equity). Home equity lines of credit usually have a lower interest rate than you can get on a credit card. So it seems appealing to get one to pay off the 18% interest rate credit card you have.
However, remember that since your home equity is tied to your home, if you are not able to pay it, the bank could end up taking your house. With unpaid credit cards, the bank usually cannot take your house. It is important to keep that forefront in your mind. Because of this a home equity is sometimes called a “secure line of credit” versus a credit card which is called “unsecured credit.”
Chapter 1. No hard and fast rule
As long as you understand that you are using the credit (which will be debt) against your house, there is no hard and fast rule when it should be used and when it should not. However, I know from experience that when one is given a lot of credit, with a low interest rate, it is hard not to spend it or use it. It is nice to have it for an emergency, but then your “emergency” definition becomes a little lax.
I tend to say “yes” to a line of credit to keep for an emergency (create a list what constitutes an emergency and stick to it), or if it would be anything to increase the value of your house: as your house is improved, the selling price of your house is improved.
Because the debt is now tied to your house I tend to say “no” to a home equity line of credit to transfer credit card debt or student loans. I definitely say “no” to buying a new car, motorcycle, furniture, vacation, or anything not permanent on the line of credit. Because if you buy that new motorcycle on home equity line of credit, and you end up not being able to pay that home equity — they can take your house away.
Chapter 2. Home appraisal
A lot of time there is a difference between what your house is worth and for what you can actually sell it for. Oftentimes a bank will need a home appraisal done for a home equity line of credit to make sure that the house is worth a certain amount. In certain cases the homeowner might have to pay for this appraisal.
Chapter 3. A home equity may complicate a refinance
With mortgage rates as low as they are right now, it is smart to at least look to see if it would be worth it to refinance. However, on a refinance, things may get complicated if you have a second mortgage. It is not just credit card debt. It is debt that raises what you owe on the home. The refinance may have to cover the home equity. However, you are now lengthening the time span of the home equity. For instance, if you had $10,000 on your home equity, which you had planned to pay off at the end of the year. By putting it into the refinance, you have lengthened that $10,000 to the new 30-year home loan.
Anytime you have maxed out a credit card – and I have done it in the past – you will probably do it with this credit. If you are good and cautious, you can trust yourself. You do what you need to do. Just remember that it is not the easy path to finance – in fact it is making it more complicated. But it can also be the safety net you need to worry less.