Pros and cons of using your home's equity

By Stacee Sledge, for The Bellingham Herald

Equity: the magic word that moves so many to eagerly enter the real estate market.

Many of us have heard the popular reproach: "Stop renting and buy yourself a house. Then you'll be building equity, rather than throwing your money out the window every month."

Now that you've followed that age-old advice and can access equity of your very own, what should you do with it?

According to Realtor Larry Humes of John L. Scott Real Estate, homeowners do a wide variety of things with equity many of them, he says, not so smart.

"The first thing about a home's equity is, first and foremost, be very careful with it and be very careful of it," he says. For many homeowners, the best way to use equity is to not touch it at all, until you're ready to sell and move up to a larger home or use the cash to retire.

Humes understands equity intricacies inside and out and warns that many homeowners use equity while they're still living in the home in ways that simply don't make financial sense. He's quick to point out equity can be used in beneficial ways, but it's vital that you do your homework before you move forward.

Changes in capital gains taxes

Before delving into the equity dos and don'ts, it's important to clear up a common misconception about capital gains tax laws, which changed drastically five years ago.

The biggest mistaken belief about equity derived from the sale of a personal home is that you must reinvest that income or risk paying capital gains tax. No longer true. Tax law changes now allow any homeowner to sell a home every two years and take a $500,000 exemption per couple or $250,000 exemption for a single person. The only restriction is that the seller must have lived in the home two out of a total of five years.

If you meet these requirements, any profit you make on the sale of your home is yours to spend however you like. You can go on a long trip, buy a motor home, purchase stocks, invest in other real estate there are no limitations placed on that money.

But with record-low interest rates and record-high instances of refinances in recent years, more homeowners are using equity to eliminate credit card debt, buy vehicles or update their home without putting their home on the market.

Humes advises that if you decide to access equity without selling your home, carefully consider what you're planning to purchase with the cash and raise the important question: Does it create an asset or a deficit? "Whatever that thing is, does it become something that pays or does it become something that decreases in value?"

Second mortgages

"First mortgages happen regularly," says Humes. "Second mortgages happen in the middle of the night. Someone will see on TV [a commercial that says] 'We can give you 150% of the value of your home!'"

"Everybody should turn the TV off at that point."

But many homeowners have been taken in by such commercials and all that they promise. And those late-night ads have helped contribute to the highest incidents of foreclosures America has ever seen.

Humes attributes this to a mentality of spending that's problematic for many people who take out a second mortgage based on the equity in their home.

"What I see out there is home loans that are at 90 or 95 percent," says Humes. "Somebody came in with 0% down or 3% down or 5% down, and then went out and got a second mortgage to pull their equity out and used it to put a new roof on, to put a deck on the back, or to buy a new truck."

Humes stresses that these second mortgages never offer interest rates as good as the first. And they're all variable rate, so they can float. "If the interest rate bumps up, all of a sudden the second mortgage is big and ugly," he says. And no longer affordable to many homeowners already drowning in consumer debt which is also at an all-time high.

"Foreclosures occur a lot of times because people get stressed about the second mortgage and stop paying it," Larry says.

And that brings Humes back to his views about the spending mentality of many homeowners today. "Once somebody does a second mortgage and shifts their mentality toward a spending mode, they usually continue. It's not really whether they put a new roof on the house or not, it's a mental shift. Once they've done that, it's like they've got this free money and they've got to do something with it. And when it runs out, the mode is still going."

And so it's become increasingly common for a Realtor to pull up a profile on a house that's in foreclosure to find, for example, a $150,000 loan taken on a $165,000 property that also has a $35,000 second mortgage far beyond the value of the house.

Pay off credit cards

Another popular reason for accessing equity these days is to pay off credit card debt. It sounds like a winner, since oftentimes the interest can be considered tax deductible. But Larry again sounds a warning bell.

"Don't pay off your credit cards," Humes insists, admitting that this opinion may differ from that of other professionals, and then continuing on to make a compelling case.

"What happens when you pay off a credit card is you'll end up paying off [the debt at] a higher interest rate," he explains. There is a tradeoff point, Humes admits. "If you've got 18% or 20% interest on your credit card, it can make sense to pay them off. But if you have an 8% or 10% interest rate, don't pay them off with home equity. Because you're going to end up zeroing out that credit card, but you're going to pay that balance for maybe 20 or 30 years, instead of paying it off with a two or five year plan. The eventual interest is huge even with a lower interest rate."

Another no-no

"Don't go out and buy a boat or car," says Humes. "Because in five or ten years what you've got is something that doesn't have much value and you've still got 10 or 20 years of paying for it."

Instead, buy appreciable assets that pay for themselves. Humes says real estate is a great investment, with limits.

"Don't buy land just land where you use equity as a down payment and have to make a monthly payment." Unless you have a short-term plan for the land, or absolutely know that it's in the way of progress and within two or three years will become much more valuable, it's not a solid appreciable asset to invest in.

"I would say buy rental investment property," says Humes, "because the tenant then pays the monthly payments and the property increases in value." But he strongly suggests contacting someone who can analyze the property before you make a purchase.

Humes believes purchasing rental property anywhere in the county is a better bet than in Bellingham , given today's current market.

"Say you can buy a duplex in Bellingham or a duplex in Everson," Humes says. "The duplex in Bellingham costs $210,000; in Everson it's $135,000. The rents in Bellingham are $650, while the rents in Everson are $550. Makes perfect sense to me I don't have to figure that one out very much. I buy rentals anywhere and everywhere I can, but I don't touch them in Bellingham at this point; they're out of hand."

Another smart way to spend equity is to remodel your home, but again it's best to think it through carefully before knocking down plaster walls or ripping out plumbing.

"There are two reasons to remodel," says Humes. "One is to get what you want and to heck with the next guy and to heck with resale ability. The other side of it is to fix a place up real nice and sell it and do really well. Two totally different scenarios."

Certain remodeling projects will pay you back in full and then some when it comes time to sell your home. According to Humes, Bellingham currently runs at about 105% return on remodeling dollars spent on kitchens, master bedrooms and master bathrooms.

But there are many remodeling projects that won't pay 100% of what you put into it, such as basements and landscaping. Humes suggests mining the web for information on which remodels pay off best.

So although those late-night television commercials Humes mentioned might appeal in the dim glow of the talking screen, wait until the light of day to make a decision. Think about how you want to use the newfound cash and make sure it makes financial sense. Then, meet face to face with a qualified professional before signing on the dotted line.

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