You've heard by now that one-quarter of U.S. homeowners with a mortgage are "underwater" on their loans, owing more than their houses are worth.
That percentage is likely to grow. Deutsche Bank predicts nearly half of mortgaged homeowners, or 25 million households, will be underwater by the time the housing recession ends. That's grim, but the flip side is that most U.S. homeowners still have equity in their homes -- sometimes a lot of equity.
Twenty-three million households have 25% or more equity in their homes, according to First American CoreLogic; 24 million households own their houses free and clear.
The question now is what, if anything, they should do with that wealth. Here's the central problem:
- If they tap their equity and borrow too much, and if home prices fall further and they have to move, they could join the legions of underwater homeowners who faced ruined finances and trashed credit.
- If they don't borrow, the equity they could have turned into cash might instead disappear.
Regular readers won't be surprised to learn I'm urging caution.
If you're lucky enough to still have equity, your priority should be keeping your head above water, not trying to turn your home's value into cash.That means capping your borrowing at 80% or less of the value of your home. Keeping at least a 20% equity pad has always been a good idea, and now it's enforced by lenders, who are reluctant to lend more. (The limit is lower in hard-hit areas such as Florida and Nevada, where 60% to 65% caps on borrowing are common.)
You'll want some breathing room in case prices fall more; people with equity have a much easier time if they have to sell.
Here are some common ways people spend their home equity -- debt consolidation, remodeling, cars and college -- and what you should think about before you join them:
Remodeling your homeRemodeling is not, I repeat, not an "investment" in your home. Though some projects add value, they won't pay for themselves, let alone offer any kind of return. (For a more detailed analysis, read "Remodeling? It's a waste of money.")
Home-improvement projects are mostly consumption spending, and we should pay for our consumption with cash. If you decide to finance, borrow no more than half the cost of the project, and make sure it really is adding value to your home.
Also note: Home repairs and maintenance typically don't add any value to your home. These projects simply maintain the value of your home and should definitely be paid for in cash. If an emergency repair is required and you don't have enough saved, make sure you quickly repay any home equity you use.
Bottom line: Restrain yourself. Try to pay cash for most projects.
Debt consolidationFor too many families, using home equity to pay off credit cards and other debt is a serious mistake.
You're not fixing the problem that caused you to overspend in the first place, and you're likely to just continue racking up debt. But now you've put your home on the line and have turned bills that could have been erased in bankruptcy into secured debt, which can't be whisked away.
A better option could be a three-year fixed-rate personal loan from a credit union. The rate you pay would be higher than what you would pay for secured debt, but you wouldn't put your home at risk.
The only time you should consider using home equity to consolidate debt is if your debt is small (that is, you're at no risk of bankruptcy), you've made permanent, profound changes to your spending and you're absolutely sure you won't carry credit card debt again.
Bottom line: Explore other solutions -- up to and including bankruptcy -- before you use home equity to consolidate debt.