Many of you have achieved that ultimate financial goal of owning a home debt-free. As comforting as that is, it might not be the best financial move. Home equity can be a low risk way to increase your after-tax wealth, especially in this era of low cost, low interest rate, easy-to-get home equity loans. I’ve played with the numbers, and I like the way they turn out.
Suppose you are considering a home improvement costing $25,000. You could tap into your investment portfolio to pay the expense, or you could take a home equity loan or line of credit.
If you pay cash for the improvement, you won’t incur any interest expenses. But you also won’t have the income and gains the $25,000 would have earned in your portfolio. A home equity loan would generate interest expenses, but the interest payments should be deductible if you itemize deductions.
That’s the trade off. How do you evaluate it? The rule of thumb is that you should borrow if your expected after-tax investment return is higher than the after-tax interest rate on a loan.
Let’s say that you want to be able to pay off the loan at any time, so you put the $25,000 in a money market fund paying 4.5%. You pay 7% interest on the home equity loan over a 15-year term, and are in the 31% tax bracket. By my calculations, after 15 years the investment account will have compounded to $39,549 after taxes, and you’ll have paid a total of $36,159 on the loan, after taking into account tax savings from the interest deductions. That makes you more than $3,000 richer by borrowing to pay the expense.
Naturally, if you invest the money more aggressively and are able to get a higher investment return, the payoff is even bigger. An 8% average annual pre-tax return on your investment would result in an investment account worth over $56,000, putting you almost $20,000 ahead.
Sometimes the numbers work out so well that I’ve known people who borrow against their homes specifically to invest. Over the last three and a half years, that has generated a big pay off for them.
But leveraging home equity to increase wealth is not for everyone. Be sure that over the life of the loan you’ll have enough “safe” income to cover the loan payments, your living expenses, and emergencies.
And consider the emotional factors. Many people get emotional security from owning their homes free and clear, even if they could live better or increase their wealth by borrowing against the home. Or they believe that borrowing against the home is only for emergencies. If you are in those categories, or you have some doubts about the security of your income, you don’t want to borrow against the home except in emergencies.
Of course, a realistic rate of return on investments should be used to determine if borrowing is the best move. It is easy to make borrowing look good by assuming that the investment returns of the last three years will continue each year in the future. But that’s not likely. That’s why I used conservative rates of return in the examples.
When you decide to borrow, remember that not all home equity loans are the same. Here are some tips for getting the maximum benefit from a home equity loan.
First, decide if you want a home equity loan or a line of credit. Under a line of credit, the lender makes a certain amount of money available through a checking account. You borrow the money by writing a check, and that’s when the repayment terms kick in. You can borrow any amount up to the credit limit. Usually the interest charged on a line of credit fluctuates with market rates over the life of the loan.
A home equity loan is the standard mortgage in which you receive a specific amount of money that is to be paid over a fixed term, and all that is set when the loan is granted.
When you get a line of credit, you want to know the amount of the credit line, how you tap it, when it might expire if you don’t use it, how payments are calculated, and whether or not there are any fees involved.
Since the straight home equity loan has a fixed interest rate and fixed payment schedule, you should consider one if you know how you will use the proceeds and how much you need to borrow. The home equity loan also is preferable if you expect interest rates to rise or want to lock in the payment amount.
The line of credit, on the other hand, is more flexible and usually has lower costs, such as points and origination fees. Lenders compete heavily to make home equity lines of credit, and in many areas there are lenders who will provide the credit lines without any initial costs.
In choosing a line of credit lender, carefully consider the following factors.
A home equity loan often is the best way to borrow these days. It also can be a shrewd way to pay for major expenses that will help increase your after-tax wealth.