Owning a home comes with a variety of perks, but few can translate to cash in hand. Home equity (the difference between the market value of your home and your current mortgage balance) is one exception. It allows homeowners to leverage their equity in the form of a home equity loan, a home equity line of credit (HELOC) or a combination of the two.
According to the Federal Reserve, the total home equity held by homeowners in the United States is over $13 trillion, and for many, their home represents their largest financial asset. By leveraging this asset, homeowners can meet both long- and short-term financial goals, such as consolidating debt or financing home improvements and repairs.
Despite the abundance of home equity in the United States, there is a lot of misinformation about what homeowners can actually do with a home equity loan or line of credit. Here are some of the biggest myths, along with a few facts to set them straight.
Myth No. 1: Home equity can only be used for home improvements.
Fact: Once home equity is converted to cash through a home equity loan and/or line of credit, borrowers are free to use the funds as they see fit. Many borrowers choose to use the funds to finance large expenses, such as home improvements and repairs, educational expenses, even debt consolidation. However, the possibilities extend far beyond just these few. For example, some people tap into home equity to help fund a new business venture. Others use it to help offset the costs of retirement. There are many ways, aside from funding a home renovation, to put your equity to good use.
Myth No. 2: Home equity loans and lines of credit are just like credit cards and personal loans.
Fact: Home equity loans and HELOCs are similar to other lending options – such as credit cards and personal loans – in that they all provide access to much needed funds. However, they vary in several ways. Perhaps one of the most significant differences, particularly when it comes to home equity, is that HELOCs and home equity loans are secured debt, while credit cards and personal loans are unsecured.
What does this mean? Secured loans are backed by an asset or collateral, in this case, a home. Because home equity loans and HELOCs are secured debt, interest rates are typically significantly lower than credit cards and personal loans, making them more affordable.
Many homeowners who have mounting credit card debt with high interest rates find that home equity represents an affordable way to consolidate and pay down debt within a fixed period of time.
Myth No. 3: Taking out a home equity loan is a long process and requires a trip to the bank.
Fact: In the past, that may have been true, but new trends in home equity lending have made it easier and faster for homeowners to tap into their home equity.
Some lenders allow potential borrowers to apply online through their desktop and mobile devices, meaning loan applications can be submitted from the comfort of your own home. Additionally, while the home equity loan process once took several weeks (and still often does), there are some lenders that can process the loan in as little as one week.
Myth No. 4: Home equity loans are no longer tax deductible.
Fact: The Tax Cuts and Jobs Act of 2017 placed new restrictions on home mortgages, and as a result, deductions for interest paid on home equity loans and HELOCs were restricted, and in some cases suspended, from 2018 to 2026. However, according to the IRS, taxpayers who use a home equity loan or line of credit to “buy, build, or substantially improve” their home may still be eligible.
The IRS website explains, “Beginning in 2018, taxpayers may only deduct interest on $750,000 of qualified residence loans. The limit is $375,000 for a married taxpayer filing a separate return. These are down from the prior limits of $1 million, or $500,000 for a married taxpayer filing a separate return. The limits apply to the combined amount of loans used to buy, build or substantially improve the taxpayer’s main home and second home.”
In short, you may be able to deduct interest paid on a home equity loan. To determine eligibility based on your own unique borrowing situation, contact a tax advisor who can guide you through the complexities of tax law.
Myth No. 5: Fees and closing costs make tapping into your home equity a costly financial solution.
Fact: Many home equity loans or HELOCs come with their fair share of fees and hidden costs – title fees, appraisal fees, closing costs, and prepayment penalties, to name a few. However, modern lenders are re-examining fee structures, and today, some have drastically cut back on those fees, creating a borrowing solution that is both affordable and transparent.
Myth No. 6: Borrowers can access the full amount of their home equity through a home equity loan or HELOC.
Fact: A home equity loan does allow borrowers to access a significant portion of their equity, but according to the Federal Trade Commission, the amount a homeowner can borrow is typically limited to 85 percent of the total available equity. In some cases, it is possible to borrow more, but many experts advise borrowers to avoid taking out the maximum available to them, suggesting instead that they keep a cushion to protect their investment should home prices fluctuate over time.
Of course, the amount of equity in your home isn’t the only factor that controls the total amount of your loan. Most lenders also consider the borrower’s credit history, income, and debt-to-income ratio when determining the total loan amount.
Myth No. 7: Home equity takes years to accrue, and therefore you must own your home for several years before you can tap into it.
Fact: In some cases, depending on the type of mortgage, home owners may have equity as soon as they make their down payment. For example, a homeowner that secures a traditional mortgage to purchase a home with a market value of $250,000 and makes a down payment of $37,000 will enter their mortgage with 15% equity.
Assuming the value of a home remains the same (or increases), home equity will continue to grow with each mortgage payment, provided it’s funded with a traditional loan. The opposite can also be true, however. Some borrowers take out interest-only loans and, for the first several years of their mortgage, pay only the interest, which means they aren’t chipping away at their loan’s principal and consequently, not increasing their equity. More importantly, if the home price falls, the equity falls right along with it. If the value of the home falls dramatically, a home could be “under water,” meaning the homeowner owes more on the home than it’s worth.
For many homeowners, leveraging their home equity offers a means to an end, be it debt consolidation, home repairs, or the next big step in life’s journey. If you’re considering a home equity loan, be sure to work with a lender that can help you separate the fact from the fiction, allowing you to make an educated decision about your current and future investment.