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Thanks to the real estate run-up of the past several years, you're sitting in a $500,000 home that you owe $50,000 on.
Wow, you're rich! You've got $450,000 in home equity. So what if you have no savings? You're sitting on a pile of cash.
Not so fast.
"Most Americans these days have more money invested in their homes than all their other investments combined, says Peter J. D'Arruda, the author of "Financial Safari."
That kind of thinking could be financially dangerous.
"If you put too much into your house, the bank has control over that money," D'Arruda says. When a financial crisis hits and you need that equity most, the bank may well not give you what's yours.
Dave Ramsey, a radio talk-show host and the author of "The Total Money Makeover," points out that the banking industry calls home-equity loans "HELs" for short. "My experience tells me they simply left off an 'L,' " he says. "These loans are dangerous, and an unbelievable amount of them end in foreclosure."
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Those who do draw on their equity may find that their home values could fall -- perhaps lower than what they've borrowed against. If you find yourself in a financial crisis and can't make the payments, you could wind up in foreclosure and lose all the "savings" you thought you had, D'Arruda says.
Something similar happened to a couple Ramsey refers to as Ed and Sally. Their home-equity line, used for emergencies, was not renewed by their bank after Ed lost his job, and they got behind on their bills. That was despite their credit having been perfect for 17 years before their financial crisis. Ed and Sally had to sell their home to avoid foreclosure.
"It is clear that many folks are spending more than they are earning, and home equity is a source of that excess consumption," says Richard F. DeMong, a professor at the University of Virginia's McIntire School of Commerce. DeMong, who is an expert in home-equity and mortgage lending, notes that when a home is the primary source of savings, it won't be available during retirement as money that one can use to live -- unless the home is sold and a smaller, less expensive one is bought.
That option doesn't appeal to many.
Still, DeMong sees home-equity loans and lines of credit as useful for home-improvement projects -- because they increase the value of the home and thus the value of the home equity -- and for dealing with temporary emergencies.
"However, for longer-term emergencies, such as a permanent disability, (home equity) is not as helpful since you will no longer have the equity for retirement or other needs," he says.
Relying on your home equity as savings can be a dangerous idea.
Here are some scenarios that make clear the dangers:
- For years you count on the equity in your home to pay for your child's college education. But just as high school graduation approaches, a stock market crash or an oil embargo creates fears and sends interest rates soaring to more than 18%, as happened about 25 years ago. It's almost better to use a credit card.
- You live in an area where home prices have gone through the roof, but a housing-bubble burst makes your home worth less than what you paid for it, meaning there is no home equity to use.
- You become subject to the alternative minimum tax (which increases your tax bill by knocking out a lot of exemptions, deductions and credits). The interest on a home-equity line of credit is no longer tax-deductible, significantly reducing its feasibility.
- Congress changes the rules on home-equity loans. For instance, government-backed mortgages could require homeowners to keep a certain amount of money in home equity to reduce the chance of foreclosure, investment expert Jeff Harris says. This could reduce or eliminate the amount available for equity loans. Or banks could be forced to tighten eligibility requirements by the Federal Reserve, so perhaps you wouldn't qualify for a home-equity loan, even if your income remained the same.
Bottom line: Home equity or not, it's still important to save.
By Melissa Ezarik, Bankrate.com
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