The relative ease with which homeowners can borrow against their home equity can make it tempting to do so, whether to pay off higher-interest debt or to cover the cost of a remodeling project. The relatively low interest rates involved in such borrowing and the tax-deductibility of the interest paid (in most cases) adds to the temptation.

But before borrowing against your house, take a clear-eyed look at whether doing so would be wise. It may seem like a no-brainer to swap high-interest credit-card debt for cheaper (and likely tax-deductible) home-equity debt. However, if you haven’t addressed the root cause behind your credit-card debt, paying it off with another type of debt may turn out to be only a temporary fix.

One widely cited study from the late 1990s found that about 70% of borrowers who used a home-equity loan to pay off credit-card debt ran up more credit-card debt within a year. Keep in mind, too, that trading unsecured debt for debt collateralized by your home is risky.

By the same token, it may seem perfectly reasonable to finance a remodeling project or some other large expense by borrowing against your home. However, it may be wiser stewardship to put off the project and save for it in advance.

With those necessary cautions in mind, we’ll now discuss three ways to borrow against your home-equity: (1) a home-equity loan; (2) a home-equity line of credit; and (3) a cash-out refinance. (We’ve written about a fourth method, reverse mortgages, previously.)

With each type of loan, you borrow against equity that you’ve paid into the property or that has come about through its appreciation. To qualify, you need a certain amount of equity in your home, a strong credit score, and a manageable amount of total debt as a percentage of income.

  1. Home-Equity Loan
    With this type of loan, you receive the borrowed money right away in a lump sum, and then begin paying the money back right away, similar to any traditional loan. Home-equity loans typically are offered at fixed interest rates, which means you will make equal monthly payments over the life of the loan. Terms typically range from 5-15 years.

    Closing costs can amount to 2%-5% of the loan value, although some lenders promote no-closing-cost loans (be sure to find out whether they’re actually free of such costs, or if the lender is rolling those costs into the loan balance or possibly charging a higher interest rate).

    Home-equity loans generally are best for one-time expenses, such as a remodeling project or a wedding.
  2. Home-Equity Line of Credit
    Instead of receiving money up front, a HELOC gives homeowners the option to borrow only if they need or want to (although some require that you take an initial draw). Once approved for a certain amount, home-equity can be tapped via special checks or a credit card. HELOCs are typically variable-rate loans tied to the prime rate.

    HELOCs also differ from home-equity loans in that there is commonly a draw period and a repayment period. The draw period, usually 5 to 10 years, is the time frame during which money may be accessed.

    The repayment period is just what it sounds like, although it can extend beyond the draw period. For example, you might have a draw period of 10 years and a repayment period of 20 years. Lenders often give borrowers the option of making interest-only payments during the draw period, switching to interest plus principal payments during the repayment period.

    HELOCs don’t require a formal closing and the fees typically are lower than those tied to home-equity loans. That said, there still may be “origination” or application fees. Plus, even if you don’t use the credit, you may have to pay an annual fee for the privilege of having access to the money.

    Because the rate may be variable, it’s best to use a HELOC for short-term needs in which the loan can be paid back relatively quickly.

    Some people use a home-equity line of credit as an “emergency fund,” but that can be risky. During the Great Recession of 2008, when mortgage delinquency rates rose and home-equity levels fell because of decreasing home values, some banks froze home-equity lines of credit at their then-current levels (or closed untapped HELOCs altogether).

    Three important aspects of home-equity debt

    Before moving to the third approach to borrowing against home equity, we need to stress key points about the two methods mentioned above.
    • Whether applying for a home-equity loan or line of credit, most lenders will require a combined loan-to-value (LTV) ratio of less than 80%. (Your combined LTV is the total of your current mortgage plus the amount of the new home-equity loan or line of credit.) For example, if you own a house valued at $300,000 and owe $180,000 on it, you have a 60% LTV ratio ($180,000 divided by $300,000). Lenders may be willing to lend you up to an additional $60,000, which would bring your LTV ratio to 80% ($240,000 divided by $300,000).
    • The tax deductibility of the interest paid is another factor that pertains to home-equity loans and lines of credit. If the borrowed money is used to improve your home, it is typically deductible with no limit on the loan amount. If it is used for other purposes, the interest is typically tax-deductible as long as the loan amount doesn’t exceed $100,000.
    • Keep in mind that if you have a home-equity loan or line of credit, you will have to pay off the remaining balance when you sell your house.
  3. Cash-out Refinancing
    This is not a second mortgage, as in the case of a home-equity loan or line of credit. It’s a new mortgage. You’ll have to foot the bill for a new appraisal and closing costs.

    You might opt for a cash-out refinancing if: (1) mortgage rates have dropped below what you are currently paying, (2) you want to take out more than $100,000 and use it for something other than a home improvement, or (3) you want longer repayment terms.

Additional guidance

Closing costs for each of these loan types can vary widely among lenders, so be sure to shop around — not just for the best interest rate but the lowest closing costs as well. Also, be sure you understand various other fees that may apply. For example, some home-equity loans and lines of credit charge a fee if you repay the loan or close the line of credit too soon (from the lender’s point of view).

As you weigh your options, it might be helpful to create a spreadsheet showing the fees, interest rate, term, monthly payment, and total payment.

SMI’s standard mortgage-related advice applies as well. It’s best to keep your total first and second mortgage, interest, and taxes to no more than 25% of your monthly gross income — preferably no more than 20%. And plan to have all such debt paid off as quickly as possible, and certainly no later than by the time you retire.

Lastly, when considering whether to tap your home-equity, while there are many financial factors to compare across loan types, the non-spreadsheet factors mentioned at the beginning of this article may be the most important ones to consider. An unwise loan is still unwise even if the rate is great and the interest is tax-deductible!