Mortgage Methods: A Simple Rule of Thumb for Home Equity

By Richard Barrington
NFNS Columnist

Home equity loans have been painted unfairly as a major culprit in the recent mortgage crisis. Such a broad category of loan is neither good nor bad in its own right; it's the way homeowners use home equity that determines whether the loan makes sense or not. Using a simple rule of thumb, homeowners can increase their chances of using home equity to their best advantage.

Using Home Equity to Your Best Advantage

The rule of thumb is this: use home equity when it is the best way of financing a purchase you could otherwise afford, and not when it is the only way of paying for something you otherwise couldn't afford.

Here's what that means. You have a purchase you want to make. Think of three ways of paying for it:

  • You could save up for it, if your monthly budget has enough slack for you to put aside an extra amount regularly.
  • You could take out a consumer loan, if your credit rating is good enough.
  • You could finance it with a home equity loan.

If the first and second paths of financing aren't possible--if you don't have that kind of slack in your monthly budget, and/or your credit rating is not that good, you should seriously consider foregoing the purchase. Even if the third option, a home equity loan, is open to you, not being able to do either of the first two options suggests you may run into repayment problems.

The Refinance Alternative

One final thought. If you meet the above test for a home equity loan, first consider whether it would make more sense to refinance your existing mortgage. If interest rates have fallen, a refinance will save you some money to help offset your new purchase. Even if interest rates are about the same as for your original mortgage, you might find refinance rates for a full mortgage are less than those for a new home equity loan.

About the Author:
Richard Barrington is a freelance writer and novelist who previously spent over twenty years as an investment industry executive.

How to Refinance

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