Are you using your home like a piggy bank? Have you been considering borrowing against your home’s equity?
If you paid cash for your house, or if you’ve built up equity while paying off a mortgage, you probably realize a good chunk of your money is tied up directly in your home. In fact, having tens or even hundreds of thousands of dollars in your home’s equity is entirely possible.
So no wonder many people are tempted to treat their homes like a money spigot and extract some of that cash to spend. Taking out a home equity loan (HEL), home equity line of credit (HELOC) or reverse mortgage may seem like a good idea on the surface. But there are serious dangers lurking behind each of these financial vehicles.
How People Get Money Out Of Their Homes
Typically, there are three primary methods people use to convert their home’s equity into cash:
A home equity loan (HEL) is simply a one-time loan. It allows you to borrow a set sum of money at a fixed interest rate from your home’s available equity. The loan terms include a pre-determined monthly repayment amount and period in which you’ll pay off the loan and the interest.
A home equity line of credit (HELOC) is not a one-time loan but an open account from which you can pull money up to a set credit limit. The available credit can be as much as 85% of your total home equity, and you can borrow more whenever you wish. With a HELOC, you’re required to make monthly payments toward your debt.
However, the payment amount will vary, depending on the cumulative amount you’ve borrowed and a variable interest rate.
A reverse mortgage is a special breed of HELOC that’s typically available only to older homeowners who have little to no mortgage debt remaining on their primary residence. Depending on the terms of your reverse mortgage, you may receive the money in installments, as a lump sum or in some other fashion. And, instead of repaying the loan monthly, you pay it off when you sell the home, move out or die.
So What’s The Harm?
While there are many reasons you might consider tapping your home equity, some of the most common include
- Making up for a shortfall in your income
- Funding your kids’ college educations
- Paying down credit card debt
- Buying a car at a lower interest rate than with a traditional auto loan
- Financing a kitchen or bathroom remodel.
These all sound like good justifications for home debt, but there’s a very real danger in taking money out of your equity. Specifically, a HEL, HELOC and reverse mortgage are all forms of secured debt attached to your home. To cut to the chase, failing to live up to the terms of your loan could cause you to lose your home to foreclosure.
Remember: credit card debt is unsecured debt. So if you miss a payment, no one can take your home or garnish your wages. And a car loan might have a higher interest rate than a HELOC, but losing your car to default is a far better scenario than finding yourself homeless. Plus, you could easily find yourself over-extended if you take out an equity-based loan and your house value plummets.
Even if you can make all your loan payments, you may still run into trouble. Your loan may require you to keep the home maintained at a level you can’t afford. Or, if you’re forced to relocate temporarily—like to a nursing home for more than a year—your loan may be called early. And that may force you to sell the house.
Want to keep your home in the family after your death? You may not be able to. Your house may need to be sold to cover your remaining debt. Or your kids could have to pony up large sums of cash just to hold on to it.
Symptoms Of A Deeper Problem
If you’re considering a HEL, HELOC or reverse mortgage, your financial need is likely masking a deeper problem: You’re using debt to support your lifestyle. Instead of feeding an Income Generator that will yield dividends for you, you’re stuck paying interest to a bank.
If you’re in debt already, you’ll find that HELOCs are just as easy to spend as credit cards. And reverse mortgages come with high fees, interest rates and closing costs. So tapping into your home’s equity for money is typically not going to solve your income or spending issues.
Pursuing one of these types of debt? Stop and take a close look at the health of your Freedom journey. Are you living outside of your means? Are you placing your home at unnecessary risk?
Most importantly, is there another way out? Look hard at your financial life to see how you can keep your family secure while paying down debt, avoiding new debt and moving toward Freedom.
Community Question: Have you run into trouble with a HEL, HELOC or reverse mortgage? Share your story in the Financial Foundations community!
Dr. Tony is the co-founder of MindShift.money and the best-selling author of three books on personal and business finances. Having achieved Financial Freedom at 27, Dr. Tony believes that through Financially Fit Bootcamp and Cash Flow Cure everyone can get there. He has made it his life’s mission to help others live a life where their money works for them—not the other way around.