Before you pay down your mortgage or decide that it isn't wise to tap into your home's equity, think twice. While you certainly want to avoid leveraging home equity to make risky investments, there are some very prudent ways to improve your financial situation without a lot of risk.
A home loan is one of the lowest cost loans available because mortgage interest is tax deductible for most people (check with your tax advisor for specifics). A home equity loan at 7% is equivalent to borrowing a 4.55% for a homeowner with a 35% marginal tax rate. By contrast, credit card rates can be 18% or higher, and auto loans average around 8%. Consolidating higher-rate, non-tax deductible debt into a mortgage will save you money.
Tax-advantaged investments, such as 401(k)s, IRAs and educational plans are often overlooked by homeowners. The Federal Reserve Bank of Chicago concluded in a recent study that many borrowers making prepayments to their mortgage rather 401(k) contributions are "making the wrong choice."
You can contribute up to $4,000 a year (so can your spouse) to a Roth IRA. Because its earnings are tax-free, you compare its investment return with your mortgage's after-tax interest rate. In the 7% home equity loan example, if you can earn more than 4.55% on your Roth IRA, it will be the better investment.
Coverdell ESAs and 529 plans are similar. Like the Roth IRA, the earnings on these educational savings plans are tax-free. If you have kids, taking full advantage of these savings plans may be a better bet than paying down your mortgage.
Are you taking full advantage of your employer's 401(k) contribution match? The match is free money that should not be thrown away. Beyond that the tax deferred earnings may also surpass the after-tax rate on your mortgage.
What about investing in the stock market? There are two reasons to be careful here. Because stock market gains are taxable, you have to reduce the earnings by your tax rate to make a comparison. Also, stock investments are inherently risky, especially if made for the short-term. Weigh that against a 100% certain return on paying down your mortgage.
How about money for a business? Businesses tend to be risky, too. But many people make a living running their businesses and borrowing may be a necessity. You situation may find using your home's equity a perfect vehicle for financing your business.
Finally, your home's equity may serve as an insurance policy against the loss of a job or an emergency situation where money is needed. In this case, a HELOC is a perfect choice. Credit that is unused in a HELOC does not cost you interest, but it is always available when the time comes. Waiting to open a HELOC until after an emergency is risky: if you lose your job, it will be very difficult to get the loan and you will pay a higher interest. The time it takes to process the loan may also play a factor.
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