The 411 on Home Equity: How To Use It Today To Build Wealth Tomorrow
This week, I break down home equity - what is it, how to access it and 5 of the best ways to use your home equity today, while still in your home, to build exponential wealth for the future.
As prospective or existing homeowners, “building equity” is a term we hear all the time when it comes to real estate and its benefits, but it often comes across as some vague, arbitrary thing that will benefit us way in the future - at retirement. While it’s absolutely true that building equity now will pay off dividends in our golden years, I don’t think we talk enough about what we can do with equity TODAY.
First, what is equity?
Before we dive into how you can use equity, we should probably discuss what it is and how you get it. Equity is the difference between what your house is worth and how much you owe on it. As you pay down the principal each month, that money is “banked” as equity, along with the amount your home appreciates each year - about 5% historically. As the years go by, the amount of equity you have in your home can become quite substantial.
I like to think of home equity as another savings account of sorts. You could choose to set aside money every month and let your savings account grow, untouched, for decades and there would be nothing wrong or bad about that decision. However, at a certain point, I believe people can have too much money saved which can cause them to miss out on opportunities to grow their net worth.
If you’re strategic and intentional with your actions, diverting some funds from your monthly savings or - as we’ll talk about more today - tapping into your home equity can be a strategy to grow your wealth more quickly than allowing it to sit and build on its own.
How Do You Access Your Equity?
A HELOC (Home Equity Line of Credit) is the most common way to access your home equity. You apply through a lender (bank, broker, etc.) as you might a mortgage. It functions similarly to a giant credit card, where your credit limit is essentially the equity of your home. However, you can determine the exact amount you want available, so it could be well below this amount.
Like a credit card, you are only charged interest on the amount that you actively use or borrow. As you repay the balance, your available credit increases. For example, let’s say you have a $25,000 limit on your credit card, but a $1000 balance. This means you have $24,000 in available credit. You pay interest on just the $1000, not the $25,0000 limit and once you pay back the $1000 balance, your available credit is restored from $24,000 to $25,000.
Unlike a credit card though, the interest rate on a HELOC is substantially lower and you’re borrowing money that’s technically yours, unlike the credit offered to you by Chase or American Express. HELOCs have a draw period - typically 10 years - where you can pull funds and make interest only payments if you choose. At the end of this draw period, you enter a repayment period - typically 15 years - to pay off the principal.
Most people are not in their homes for this 25 year period. 13 years is the average amount of time to stay in one home. What typically happens is that people make low, interest only payments over the 10-year draw period and then pay the balance off when they sell their home. Of course, you can pay the balance sooner and have the funds become available for you to access again for other things.
HELOCs are incredibly flexible, often tax-deductible and come with much lower interest rates than credit cards or personal loans. However, it’s crucial to be strategic with how you use them and not advised for discretionary or luxury purchases. Think of them as a vehicle to grow your wealth. Now, let’s get into how.
Five of the Best Uses For HELOCs
1. Home Renovations and Repairs:
For most people, their home is their most expensive investment and largest piece of their longterm wealth plan. It’s crucial that you protect this investment with regular maintenance and upkeep to ensure maximum resale value down the road. Should large scale issues arise such as foundation problems or a leaking roof, using a HELOC to make these repairs can be an excellent idea if you don’t otherwise have the funds available. These repairs are also tax-deductible.
Even if you don’t have large scale issues, a HELOC can be incredibly helpful as you prepare to list your house for sale. Most potential buyers want a home that’s as turn key and updated as possible, especially in the kitchen. They may not even come tour your home if they see a dated kitchen in the listing photos. A kitchen remodel averages a 90% return on investment, absolutely worth the cost before listing your home. Many sellers don’t have the cash for these projects readily available, so using a HELOC for select, high-return projects is a smart way to net a higher sales price.
2. Down Payment Towards Next Home
We know that the average second time home buyer has a down payment amount more than twice that of the first time home buyer - 13% vs. 6%. This increased down payment is largely due to the equity built in their first home. What many people don’t take advantage of, though, is tapping into this equity to make their next purchase before they’ve sold their home.
If you wait to sell your home before making the next purchase, you have to find a place to live in the interim, both while you sell and while you search for your next home. Wouldn’t it be easier to close on your next property from the comfort of your current home and just move once? You can do so by using your HELOC as the down payment on your new home. You’ll make small, interest only payments over the period while your home is on the market and then immediately pay back the balance upon closing.
3. Investment Property
This option is likely not for the risk-adverse, but, when done strategically, can be a great way to build wealth. Unlike the first two options which present a clear return on investment for the asset you’re borrowing against and are pretty fool-proof, this option is all about leverage. Wealthy people are comfortable with the idea of leverage, using borrowed money to make more money, and, in many cases, it’s at the root of their success.
If real estate is part of your longterm wealth plan and you envision yourself owning a few rental properties, the idea of saving a downpayment alongside your existing mortgage and expenses can be daunting and - as I always say - you can’t “outsave” the market. Instead of saving for a decade to buy one investment property, you could opt to use some of your home equity to fund a purchase today. As that second property starts building equity and generating passive income, you could roll those profits into the purchase of a third, fourth, fifth property and so on.
I do love this option to build wealth more quickly and exponentially, but would recommend being very strategic with the homes you purchase and working with a broker who really understands this investment mindset to help you make the best choice in property.
4. Education Expenses
Transparently, this is not an avenue I’d want to take, but many people use HELOCs towards education and there are reasons why it could make sense for you. College tuition is typically due upfront for the semester. If you don’t have the funds available to pay upfront, but could pay a bit from each paycheck, this could be an option where you make that biweekly payment directly to the HELOC. It also allows your child to begin making payments right away rather than waiting until graduation and being saddled with a huge balance. Let’s say you pay part of the balance with weekly paycheck contributions. Your child could work a summer job and pay the remaining balance with their earnings and keep their post-graduation loan balance as low as possible.
Using a HELOC for education will depend on what prevailing interest rates are for both home equity loans and federal loans like PLUS loans are. You’d, obviously, want the HELOC to have the lower interest rate for this to make sense and not all banks approve the use of a HELOC for education expenses.
5. Starting a Business
This option feels a little too risky for my personal tolerance, but could work for some. Accessing funds through a HELOC is much easier than applying for a business loan and interest rates are lower. This is another example of leverage - borrowing money to make money - but one I’m less comfortable with because the risk of failure with a business is so much higher.
There are countless more ways to consider using a HELOC - from consolidating high interest debt to having a larger safety net available in case of an emergency. The important thing is to be very strategic with how you use them and always have a strategy for repayment. Try to avoid using them for discretionary, unnecessary expenses and focus on using them a way to build your longterm wealth exponentially.
If you’re interested in learning more about HELOCs, how much equity you might have or what rate you might be offered, I’d love to connect you with a few trusted lender partners to interview. And if you’re interested in using your HELOC to purchase or sell properties, I’d love to be a resource for you in the journey - either working with you directly or referring you to a trusted expert in your area.