Homeowners might be feeling richer lately, and it’s not necessarily because the recent tax cut has left more dollars in their paychecks. Rising home values are creating record levels of home equity.
Recent data from the Federal Reserve show that American homeowners have an estimated $14.4 trillion in equity, an amount that grew by nearly $1 trillion last year.
“People have more home equity now than they did at the height of the housing bubble, partly because of climbing prices and partly because people are staying in their homes longer, which gives them more time to appreciate,” says Joe Mellman, a spokesman at the consumer credit reporting agency TransUnion. “At the same time, we haven’t seen people borrowing as much from their home equity as they did in the past.”
Equity, which is the difference between your home’s value and your mortgage balance, accumulates from paying down your loan and from the increase in home prices.
Since May 2012, prices measured by the Standard & Poor’s/Case-Shiller national index have increased annually by an average of 6 percent.
The last time home prices rose dramatically, creating an abundance of equity, many homeowners overborrowed, up to 100 percent of their home equity, in some cases. When home prices dramatically dropped during the housing crisis, owners who needed to sell their homes had to bring money to settlement because their mortgage balances exceeded their home value.
“We saw people in 2005 and 2006 pulling out their home equity and using their home as if it was an ATM,” says Skip Johnson, a financial adviser and founding partner of Great Waters Financial. “People used their equity for vacations and cars, and then they lost their equity when their home value dropped. It’s better to be cautious about how you use your equity. Maybe you don’t want to pull out too much, just in case your home isn’t worth as much in a year or two.”
Although financial planners recommend leaving your equity untouched until you’re ready to sell your house, many homeowners are tempted by the ready cash. Black Knight, a real estate data analytics company, estimates that $5.4 trillion in home equity is accessible to homeowners. The estimate is based on the assumption that most lenders require homeowners to keep at least 20 percent equity in their homes. The $5.4 trillion is 10 times the amount of equity that was available in the pre-recession peak in 2005, when home values spiked.
Before you start spending your home equity, remember the recent tax law changed the rules about deducting interest paid on a home equity loan or line of credit.
“You can only deduct the interest on a home equity loan or line of credit if you use the money to buy or improve your home,” Johnson said. “You can’t deduct it if you use the money to consolidate debt or buy a boat or pay your kid’s college tuition.”
You also can only deduct interest up to a combined mortgage balance of $750,000.
“How much the deductibility of interest matters depends on whether you itemize your tax deductions,” Johnson said. “Now that state and local income and property taxes are capped at a maximum deduction of $10,000, and the standard deduction has been increased, it’s expected that fewer people will itemize their deductions. If you take the standard deduction, then you don’t have the option of itemizing your mortgage interest anyway.”
Mellman doesn’t expect the tax law to lessen the number of homeowners who borrow from their equity because interest rates remain low and equity is high.
Perhaps because they are still smarting from the problems created by overborrowing during the housing crisis, homeowners have been reluctant to tap into their home equity. In 2017, homeowners borrowed $262 billion with cash-out refinances and home equity lines of credit (HELOCs), according to Black Knight. Although that’s a post-recession record in dollar amount, it represents just 1.25 percent of available equity.
TransUnion anticipates 10 million homeowners will open a HELOC between this year and 2022, up from the 4.8 million HELOCs opened between 2012 and 2016.
“There are about 70 million potential home equity line borrowers who have more than 20 percent in home equity and no disqualifying credit issues such as a bankruptcy,” Mellman said. “Our research also shows that people who have a HELOC are likely to refinance into a new HELOC when they get near the end of the draw period.”
HELOCs typically have an interest-only initial period, followed by payments of principal and interest. These lines of credit usually have a floating interest rate tied to an index such as the bank prime rate. Borrowers see a significant payment jump when the loan switches from interest-only to a fully amortized loan. Their interest rate also will rise when mortgage rates increase.
“HELOCs are an attractive option for consumers because they typically have a lower interest rate than credit cards and personal loans,” Mellman said. “Depending on the amount of equity you have in your home, you can often have a large line of credit.”
Two other ways homeowners can take cash out of their house are to apply for a cash-out refinance or take out a traditional home equity loan. The option you choose depends on how much you intend to borrow and for what purpose, as well as your individual financial circumstances.
“I usually don’t recommend a cash-out refinance unless you have a very specific purpose for the money and you want to extend your payback time over 15 or 30 years,” says Susan McHan, chief executive of Opes Advisors. “The advantage of a cash-out refinance is that you can choose a fixed-rate loan at about 4.25 or 4.5 percent. But your loan balance will be higher, so it doesn’t make sense just to do this to have the cash around.”
If you need a significant sum of money for a big project, such as adding a bedroom or other home improvements, Johnson said, a cash-out refinance could be the best solution because of its fixed rate and long term.
Whether you can deduct the interest portion of your new loan depends on how you use the money. If the cash is for a home improvement, it should be tax-deductible. But if the funds are for another purpose, it might not be.
A HELOC makes more sense, McHan said, if you plan to move before the fully amortized payment period begins. Depending on how much you borrow and your credit score, McHan said, a HELOC interest rate is about 5.5 to 5.625 percent.
The third and less popular option is a traditional home equity loan, sometimes called a second mortgage. It can be more difficult to qualify for and can have higher closing costs.
“You’ll typically have a higher interest rate, and it will fully amortize from the beginning,” McHan said. “But it does have the advantage of a fixed rate.”
Although financial advisers tend to be guarded about tapping into your home equity, there are times borrowing against your house could make sense.
“The most recent set of HELOCs we’ve seen are mainly used for a major expense such as a home remodel, debt consolidation or refinancing an older HELOC into a new one,” Mellman said.
Taking advantage of your home equity can be a sound financial strategy but it’s not without risk. The biggest danger is not being able to repay your loan, needing to sell your home in an emergency sale or losing it to foreclosure. Other forms of debt, such as credit cards and personal loans, are not tied to your house, and don’t carry the threat of losing the roof over your head.
“Your home is a great asset, but please use it wisely and protect it,” McHan said. “That’s become even more important than ever now that people are living longer and are more responsible for their own financial security.”
● Buying a home: Taking out a HELOC before putting your house on the market could make buying your next home easier, particularly if you are buying your next place before selling your current home, Johnson said. You can use the HELOC for the down payment on the new house and then pay it off when you sell the old house without having to liquidate savings or investments. The catch is you need to qualify for the payments on all three loans: the HELOC, your current mortgage and your new loan. And you have to hope your old house sells quickly.
“Younger people who have built up a lot of equity in a starter home may think they should use it to buy a bigger house or move to a new neighborhood, but I caution people against using up all of their cash,” Johnson said.
A HELOC can be part of a purchase strategy to avoid paying private mortgage insurance. A buyer can make a 10 percent down payment and finance the purchase with an 80 percent first mortgage and a 10 percent HELOC.
A HELOC used to buy a home is tax-deductible.
● Remodeling: Johnson says the smartest use for home equity is home improvement. “Because you are putting the money into an asset you own,” he said. “Even though you won’t necessarily get a dollar-for-dollar return, you’re likely to help your home value improve over time.”
A HELOC used for home improvement is tax-deductible.
● Retirement preparation: Part of planning for retirement should include evaluating your home equity, Johnson said.
“If you’re retiring in a few years and plan to stay in your home, you may want to take out a HELOC even if you don’t need the money now,” McHan said. “This turns your home equity into a liquid asset. And unless you draw it down, there are no payments to make on the HELOC.”
McHan advocates setting up a HELOC before you retire, because borrowing money in retirement can be more complicated.
Using a HELOC for cash or bill-paying is not tax-deductible.
● College tuition: Some parents plan to use a home equity loan or HELOC to pay for their kids’ college education, but Johnson and McHan caution against relying heavily on it. Borrowing a lot now could lead to substantial mortgage payments in your retirement years.
“At least look into financial aid first and only use a HELOC as a back-up plan,” McHan said.
A HELOC used for tuition is not tax-deductible.
● Debt consolidation: Transferring debt with a high interest rate to a lower-interest home equity loan or with a cash-out refinance can be a smart move, but tax reform has eliminated the deduction of your interest payments, Johnson said.
“Using home equity for debt consolidation can be dangerous, because even though it’s good to pay off debt there’s nothing to stop you from getting into debt again,” McHan said. “This is particularly dangerous for people living paycheck to paycheck, especially if their home value drops.”
Using a HELOC for debt consolidation is not tax-deductible.