Cash-strapped middle class families may be richer than they think. Or at least, that could be true if they have owned a house for a while. Equity in a home – that is, the value of a property in excess of any mortgage balance – can be a powerful financial tool if used correctly.
Home equity loans allow you to use your home equity to finance other expenses. The thing I like about home equity is that it can let a person live out their dreams. However, tapping into equity can also be a recipe for disaster if not done properly. It's very important to have a committed, disciplined approach to what you're going to do with that capital. Blowing it on a vacation, for example, can leave you in debt and without anything to show for it.
For those who are ready to make the most of their home equity, here are five options;
Finance an expensive purchase. Using home equity to pay for a major purchase can make financial sense. Home equity loans often have low interest rates, and interest payments are typically tax deductible for those who itemize their federal return. The danger of using home equity is that a borrower might be tempted to extend the repayment period. While a new car loan usually has a five- to seven-year term, a home equity loan can run 10 years or longer. When you get into them, you have to have a plan to pay them off. Otherwise, the car ends up costing you a fortune because of the carried interest.
Buy investment properties. Opening a home equity line of credit in order to be able to pounce on investment opportunities as they occur, could be a good investment opportunity, if you know what your doing. It provides the flexibility to get into a deal that you couldn't [otherwise] get into. Rental properties, in particular, may only be available to those who are able to make large down payments. Having a home equity line of credit open in advance means buyers can quickly access the cash needed to close a sale. However, I'm not sold on the idea of using home equity to buy other investments such as stocks and bonds.
Improve your home. One of the more common ways to use a home equity loan is to make renovations or upgrades to a property. There is an opportunity for a return on investment. You're improving an appreciating asset. However, experts caution against funding a home renovation for financial gain alone. While improvements can increase the value of a house, homeowners almost never recoup their full cost. Instead, use equity only for renovations that will give you greater enjoyment or longer use of the property. For instance, making a house more accessible so you can age in place or adding a room for a new child so you won't have to move can both be smart uses of home equity.
Pay for long-term care. Cash-poor but house-rich seniors may be able to pay for long-term care expenses with their home equity. Reverse mortgages are specifically designed to provide older Americans with an ongoing source of cash, but they can be complex and restrictive. Regardless of whether a senior uses a home equity line of credit or a reverse mortgage, I urge people to be practical when it comes to using capital for this purpose. I am not a fan of getting a home equity loan and using it for daily expenses. For some, it might make more sense to simply sell the property and downsize or move to somewhere more affordable.
Ride out a market downturn. The shift from traditional pensions to 401(k)s and IRAs means a retiree's nest egg is often subject to the whims of the market. Having a home equity line of credit waiting in the wings can help limit financial damage during a recession. If you hit a hiccup in the market, rather than draw down a depressed portfolio, we can use money from the [home equity]. As with other investments, this strategy typically works best if you already have a line of credit open. While there is a setup cost, it can be worthwhile if it allows you to access cash immediately. It's a tool in your tool shed that you can use when you need it, but you don't have to.
Borrowing against your home equity isn't something to be undertaken lightly. However, when used for one of these purposes, it can be money well-spent.
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