Making home equity work for you

By Bankrate.com

If you're like most Americans, your home is your most valuable asset and your mortgage payment is almost certainly your largest monthly payment. With so much money tied up in one item, it's important to understand the role your home plays in your overall financial picture.

Is it smart to take out a home equity loan for home improvements? Is it wise to tap equity for higher education expenses? Should you scrimp to make extra payments to principal each month?

The home equity equation has become more complex in recent times, due to deteriorating conditions in the housing market. Although homes in some regions of the country are seeing modest price appreciation, many homes have fallen in value. In the year through September 2008, the national median price for housing declined 9 percent, from $210,500 to $191,600, according to the National Association of Realtors. Naturally, under these conditions lenders have retreated from heavily marketing home equity loans.

However, such loans are still available. Getting a loan in this new housing landscape depends on several factors, including your particular financial situation, tighter credit issuing standards and the less lofty real estate appraisals, says John Pallaria, a Certified Financial Planner and adjunct professor in Boston University's CFP Program. Here Pallaria takes a look at possible uses of home equity.

Heading to retirement

"You always want to be debt-free going into retirement," Pallaria says. As a homeowner, any equity you have in your home is similar to money in the bank and can only help you when you retire. That said, think about these three things before funneling money into your home:

1. Pay down loans with highest interest rates first. While it's important to look for the highest rate of return when investing, when repaying debt, work to eliminate your highest rates first. Pallaria recommends paying off all credit cards on which you carry a balance. Once you pay them off, use your funds to pay the principal off on other types of loans, such as car loans.

2. Fully fund 401(k)s. Always take advantage of employer matching contributions. In fact, Pallaria recommends maxing out your retirement plan before funneling extra money into building home equity. "Leading up to retirement, fully funding your employer-sponsored retirement plans and any IRAs would be an important consideration," he says. For 2008, IRS rules allow you to contribute up to $15,500 per year to your 401(k) account -- $20,500 if you're over 50 years old and making catch-up contributions.

3. Defer prioritizing home equity if home values are depreciating. If the market in your area is sliding, Pallaria suggests you exercise caution and put less emphasis on tapping home equity. Many people count on the equity in their home to help sustain them in retirement, but a house is not always the high-yield investment it first appears to be.

"If home values have gone down and now you're tapping into the equity, a) how much are you borrowing and, b) while in retirement do you have other sources to pay back that loan? I think that's a very important component here."

Building home equity

Looking forward to the mortgage-burning party but finding it tough to set aside extra funds? Follow these tried-and-true strategies to pay off your mortgage faster and to build home equity:

• Raises. Set aside a portion or the full amount of any raise you receive for paying down mortgage or equity loans.
• Extra payment. Send an extra payment to your lender at the beginning of month. Or apply any money left in your checking account at the end of the month to your loan's principal.
• Shift funds. If you've been paying down credit cards, shift the money to your mortgage payment after you pay off your cards. You're already used to paying out that money anyway.

Need a loan?

If you know you need to borrow, home equity loans can be an excellent way to satisfy cash flow needs, says Pallaria, who considers their tax deductibility an important part of the equation. But he also cautions that it's important to weigh all your options carefully.

Further, lenders are clamping down on credit and underwriting standards, so even if you have a decent amount of equity built up, you're likely to find it tough to get a home equity loan if you don't fit today's mold of eligible borrowers.

"I think people certainly need to have credit scores north of 700 or maybe even north of 750 these days to really be able to secure a home equity loan, because having equity is one side of the story, being able to pay it back is the other," he says.

Continued: Weigh your options

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