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
Home equity loans ideally should be used to finance home improvements or consolidate debt at a lower interest rate — but not to cover holiday, vacation or everyday expenses, buy a car, or invest.
What should you not use a home equity loan for? ›
Home equity loans ideally should be used to finance home improvements or consolidate debt at a lower interest rate — but not to cover holiday, vacation or everyday expenses, buy a car, or invest.
Is it smart to use home equity to pay off debt? ›
Using a HELOC for debt consolidation can open up the doors to lower interest rates and streamlined payments. But it also carries risks. With a HELOC, your home is used as collateral, and you could lose it to foreclosure if you fail to make your payments.
Is it a good idea to take equity out of your house? ›
Key Takeaways
If you can't keep up with payments, you could lose your home. Home equity loans should only be used to add to your home's value. If you've tapped too much equity and your home's value plummets, you could go underwater and be unable to move or sell your home.
What is the downside to a home equity loan? ›
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.
Can you spend a home equity loan on anything? ›
Can you use a home equity loan for anything? Yes, once you are approved for a home equity loan the money is deposited into your account and you can use the funds for all types of purchases.
How can I use my home equity without selling it? ›
Home equity loans, home equity lines of credit (HELOCs), and cash-out refinancing are the main ways to unlock home equity. Tapping your equity allows you to access needed funds without having to sell your home or take out a higher-interest personal loan.
What is the smartest way to use home equity? ›
The best ways to use home equity include making home improvements, consolidating high-interest debts, paying for college or elder care, or making investments in another home or business.
Can I take equity out of my house without refinancing? ›
Yes, you can take equity out of your home without refinancing your current mortgage by using a home equity loan or a home equity line of credit (HELOC). Both options allow you to borrow against the equity in your home, but they work a bit differently.
Can you pay bills with a home equity loan? ›
You can borrow on your home's equity to pay off revolving debts like credit cards, non-mortgage loans and bills. This article will show you when tapping into your home's equity might fit your situation, and it will also cover alternative debt consolidation options.
As we mentioned in #1 above, failure to pay on your home equity loan can result in your losing your home. If you can't make your payments, the lender could foreclose. You may think you have a secure job and then the unexpected happens and you lose it. With it goes your ability to pay on your loan.
Is a home equity loan tax-deductible? ›
Bottom line on home equity loan tax deductions
The interest on a home equity loan is tax-deductible, provided the funds were used to buy or build a home, or make improvements to one, as defined by the IRS.
What happens when you use equity from your home? ›
You'll receive the funds in a lump sum, then make regular monthly repayments amortized over the term of the loan, typically as long as 30 years. Because your home is the collateral for the loan, the amount you'll be able to borrow is related to its current market value.
Do I need an appraisal for a home equity loan? ›
Lenders require an appraisal for home equity loans to protect themselves from the risk of default. If a borrower can't make monthly payments over the long-term, the lender wants to know it can recoup the cost of the loan. An accurate appraisal protects borrowers too.
Does a home equity loan hurt your credit? ›
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.
What happens if you don't use your home equity? ›
Even if you open a home equity line of credit and never use it, you won't have to pay anything back. Keep in mind that whether you use your line of credit or not, you may be charged an annual fee, which is the cost you pay for having the line of credit available for when you need it.
Which of the following would not be a good use of a home equity loan? ›
Final answer: Buying a new boat would not be a good use of a home equity loan.
What are you allowed to use a home equity line of credit for? ›
Use a home equity loan or line of credit to pay for large purchases such as education expenses3, a vacation, major appliances or a vehicle.
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.
When should you use home equity loan? ›
10 reasons to use a home equity loan
- Home improvements. Home improvement is one of the most common reasons homeowners take out home equity loans or HELOCs. ...
- Education costs. ...
- Debt consolidation. ...
- Weddings. ...
- Business expenses. ...
- Investment opportunities. ...
- Retirement income. ...
- Funding a vacation.
