How to Use Home Equity Wisely

What Is Home Equity?

Home equity is how much of your home you own outright—determined by calculating the home value minus what you owe on your mortgage. So, if your home was valued at $300,000 and you owe $200,000 on your mortgage, you have $100,000 in equity. 

Here’s what’s great about equity: it automatically increases with housing prices. If the value of the average home in your neighborhood increases, you’re probably earning extra equity just by continuing to live in your home! And as we’ll explain next, home equity can be a valuable financial tool. Let’s explore what a home equity loan can be used for.

How to Utilize Home Equity

What can a home equity loan be used for? Financially responsible homeowners can positively leverage their home equity for long-term gains in a few ways:

1. Make Home Improvements That Increase Home Value

One of the most popular strategies for how to use home equity is to invest it back into your home to increase its overall value. If done right, you could get more back than the cost of the upgrades when it comes time to sell.

Common strategies for what a home equity loan can be used for include adding an extra bedroom or bathroom, adding smart home functionality, as well as knocking out long-term fixes like updating your HVAC system, repairing the roof or replacing it, and fixing old, leaky plumbing.

2. Pay Off High-Interest Debts

Using home equity can become a powerful way to consolidate and pay off high-interest debts under a new fixed rate—often lower than what you’re currently paying.

Home equity loans can be especially impactful when paying off credit card debt, auto loans, personal loans, and student loans—all of which can quickly compound out of control.

A word of caution, however: when you’re deciding what you can use a home equity loan for, you should only use it to pay off debts if you’re positive you’ve developed the responsible financial habits to avoid falling into severe debt ever again. If you’re unsure, talk to a financial advisor beforehand for guidance on making the best decision for you

When Not To Use Home Equity

We reviewed how you can use equity in your home wisely. Unfortunately, some homeowners end up using home equity irresponsibly and actually create additional long-term problems for themselves. Avoid using your home equity to pay for the following:

1. Travel

Paying for vacation—even that once-in-a-lifetime dream vacation—is a poor use of your home equity because it’s not a financial investment that will pay off over time. 

2. Vehicles, Toys, or Gadgets

Generally speaking, you shouldn’t use your home equity to purchase boats, RVs, ATVs, VR headsets, drones, or any other expensive equipment or technology that will quickly depreciate. 

3. Cosmetic Home Updates (Or Similar Investments)

Not every home update is a slam dunk for increasing home value. A new layer of paint in the guest room, for example, doesn’t exactly increase your home’s liveability. However, adding on an addition, updating that spare room so it qualifies as a bedroom, or adding a shower to the powder room can provide a serious lift to your overall home value. 

But don’t get too carried away. A hot tub or swimming pool might seem like a great idea, but these features require considerable maintenance every year, and that could deter some future buyers and ultimately have zero impact on your overall home value. 

How to Choose Between A HELOC And A Home Equity Loan

When leveraging your home equity, you have two main options: a home equity loan and a HELOC (home equity line of credit). When deciding between the two, consider your financial situation, the purpose of the loan, and your ability to manage repayments.

Home Equity Loans

With a home equity loan, you borrow a lump sum of money and typically have a fixed interest rate. You’ll pay it off in monthly installments, much like you would with a mortgage.

Pros of a Home Equity Loan:

• Fixed Interest Rate: Enjoy the stability of predictable monthly payments throughout the loan term.
• Lump Sum Payment: Receive a large amount of money upfront, ideal for covering significant, one-time expenses.
• Predictable Monthly Payments: Budgeting is easier with consistent payment amounts.

Cons of a Home Equity Loan:

• Risk of Foreclosure: Your home serves as collateral, so failure to make payments can result in losing your home.
• Potential Upfront Costs: There may be fees and closing costs when securing the loan.
• Long-term Commitment: These loans often have long repayment terms, which can span decades, committing your finances for an extended period.

Best For:

• Major Home Improvements: Great for financing renovations that add value to your home.
• Debt Consolidation: Useful for combining high-interest debts into a single, lower-interest loan.
• Significant One-Time Expenses: Suitable for large expenditures such as medical bills or education costs.

Home Equity Line of Credit (HELOC)

In a HELOC, you can borrow or draw money from an available amount. The interest rate on a HELOC may also change over time, so the amount you pay back could vary from month to month.

Pros of a HELOC:

• Flexibility: Borrow only what you need, when you need it, similar to a credit card.
• Interest-Only Payments: During the draw period, you may have the option to make interest-only payments, which can lower your initial monthly payments.
• Revolving Credit: Access to a revolving line of credit allows for ongoing financial needs and projects.
• Tax Deductible Interest: Interest payments may be tax-deductible if the funds are used for home improvements, subject to IRS regulations.

Cons of a HELOC:

• Variable Interest Rates: Interest rates can fluctuate, leading to unpredictable monthly payments.
• Risk of Overspending: Easy access to funds may lead to overspending and accumulating more debt than you can manage.
• Collateral Risk: Your home is used as collateral, so failure to make payments can result in foreclosure.
• Potential for Rising Costs: Some HELOCs have fees, including annual fees and transaction fees, and the repayment terms can change, increasing costs over time.

Best For:

• Ongoing Home Improvements: Ideal for projects with expenses spread out over time, allowing for flexible borrowing as needed.
• Emergency Fund: Can serve as a safety net for unexpected expenses due to its revolving credit nature.
• Variable Expenses: Suitable for those with fluctuating financial needs, such as business owners or investors.

Don’t Worry. Be Warranty, with American Home Shield 

At American Home Shield®, we believe that a home warranty is more than a piece of paper. It’s a state of mind knowing you’re protected when inevitable breakdowns occur in your home. If you’re investing in your home’s value with a home equity loan, get the additional support and protection you need with a home warranty from American Home Shield. We can cover major parts of your HVAC, electrical systems, kitchen appliances, and much, much more.

Not sure what a home warranty is? No worries! Check out our FAQs or contact us to learn more.