Will a Home Equity Loan Help or Hurt Your Finances? Here's How to Figure It Out

If you bought your house recently, you've probably got heaps of equity. But feeling rich is one thing; acting rich is another, say financial professionals. Just because you have equity doesn't mean you should spend a slice of it on home improvements. Here's how to drill down to core reasons why you should or shouldn't borrow against your house.

Kim Cornelison

Ask yourself how long you plan to stay in your home.

Regardless of the type of loan you take out, the most important consideration is how the loan might affect your ability to buy another house. If you are planning to stay indefinitely and pay off the loan before you move, you'll restore the equity you borrowed. But, according to Martin Seay, head of the department of personal financial planning at Kansas State University, if you think you'll probably move within seven years, as most Americans do, "don't you want that equity for your next house?"

Sure, the value of the house might rise enough to make up for the deduction of the loan, but, it might not, cautions Seay. Once the loan erodes your equity, you cannot easily restore it to add to the down payment for your next house, he points out.

Don't get freaked out by the potential of a market crash.

Many of today's homeowners likely still feel the cold chill of the home equity meltdown of 2007 to 2008, even if that was long before they purchased their own houses, says David Kottman, director of lending for Neighborhood Housing Services of Chicago, a nonprofit that guides buyers through the intricacies of homeownership.

Luckily, today's homeowners don't have to navigate that era's maze of complicated loans, says Kottman: "You literally can't replicate the problems of 2007 to 2008, because those loan forms don't exist anymore," he says.

Get educated on the types of loans.

Fixed-term loan

Home equity lending comes in several basic forms. The most straightforward is a fixed-term, fixed amount loan. For instance, say you want to remodel your kitchen and contractors tell you it will probably cost about $40,000. Taking out a fixed-term loan for $47,000 hands you both the money for the project and a set payment (usually monthly) for paying it back. You'd borrow a little more than the project budget to allow for overruns, especially in this era of supply chain complications and erratic costs of construction commodities, like lumber.

Cash-out refinance

If you haven't refinanced or purchased your house in the past several years, a refinance loan that includes a chunk of cash—known as a "cash-out refi"—is a good option, says Kottmann. "Chances are, you will lower your mortgage interest rate while getting money for your purpose," he adds.

Home equity line of credit (HELOC)

Home equity lines of credit represent a more risky way to borrow against your equity—risky because it's tempting to spend money that's just sitting there, available.

"It's insidious. When the money is sitting there, it's awfully easy to use," says Seay. "Use a HELOC as a last resort," agrees Kottmann.

Be wary of adjustable interest rates. If your home equity loan is based on a rate that the lender can raise, you will be paying more for the same loan. Greg McBride, the chief financial analyst for Bankrate, which tracks lending terms for consumers, predicted in January that home equity line of credit rates would rise this year, reaching 6.25%.

Determine the value of your investment.

The final piece to the puzzle, says Seay, is to parse the value that the home improvement loan actually adds to your house. It's important to differentiate improvements that you want for your own convenience or lifestyle from those that are highly likely to add to the market value of your house.

Seay himself faced this decision recently when he and his wife bought a ranch house with a barely functional, small deck. The $30,000 he plans to spend on replacing it with a bigger, safer, fancier deck won't entirely be added to the value of the house, says Seay, because the house already had a deck. If he had to turn around and sell the house with the new deck, a potential buyer might not put the same importance on the deck that Seay and his wife do.

But it's worth it, says Seay, because the deck substantially adds to the useability of the house for his young family. Similarly, he said, improvements that enable a homeowner to age in place, such as an accessible kitchen, might add extend the owner's ability to live independently, thus avoiding a costly assisted living facility.

Brand-new homeowners might consider taking out a modest home equity loan to address functional issues raised in the pre-purchase home inspection, points out Kottmann. "I tell people, 'I know you want a nice, new kitchen, but first look at the big-ticket items for deferred maintenance. Will you need new windows or a new roof? These things will hit you down the road. After that, look at where you will get your value back. Typically it's kitchens and bathrooms."

"The most important thing is to understand your values and what your financial goals are," says Seay. "Before you think about tapping your home equity, think about what you are trying to accomplish."