Do you need cash to pay for home improvements, your kid's college tuition, or any other reasonable expense? Using a home equity loan or home equity line of credit allows you to borrow cash at relatively low rates, using your home as collateral. The upside of this kind of financing is that because the loan is secured by real estate, the lender's risk is lower and you get a better interest rate. The potential downside is that if you don't make your payments, you could lose your home to foreclosure. Here are several tips to help you get the most from home equity loans while minimizing the risks to your finances.
Avoid Stupid Uses of Home Equity
Home equity lines allow you to tap into the ownership of your real estate, exchanging home equity for cash. You can generally borrow against 80 to 90 percent of the appraised value of your home. One of the risks of home equity loans is that their terms – low interest rates, low payments and long repayment periods – make it almost too easy to spend money. You could find yourself paying off a spectacular vacation or a new car for the next 15 or 20 years – long after the car has given up the ghost and the vacation's been forgotten. Rule of thumb – don't finance short-term assets with long-term loans.
One of the riskier uses of home equity is debt consolidation. Yes, it makes sense to pay off high-interest credit cards, and the lower payment of a home equity loan could provide some breathing room for the cash-strapped homeowner. However, experts estimate that 75 to 80 percent of debt consolidation attempts fail because borrowers continue bad spending habits and run account balances back up. Their finances become even more toxic with no home equity, accounts once again maxed out and a home equity loan to repay. It's a recipe for bankruptcy and / or foreclosure.
Home equity is accrued slowly by paying your mortgage faithfully over many years and by property appreciation (which averages about four percent per year). It's one of the most reliable ways for middle and working class people to accumulate wealth in this country. This is why you should leverage home equity only when necessary, avoiding the temptation of frivolous spending.
Smarter Uses of Home Equity
Because home equity loans are some of the least expensive forms of financing available, using it to pay for investments can increase your returns. For example, if a $40,000 bedroom addition would add $50,000 to your property value, you earn a $10,000 profit -- if you pay in cash. If you finance your addition with a credit card and the interest costs $15,000, however, you lose $5,000 by improving your home. If you can finance your addition with a home equity loan for $2,500, you still earn $7,500. That's a respectable 118 percent return on investment.
The same goes for other uses – home equity can finance an education or allow you to invest in anything from real estate to stocks. It can pay for expensive medical procedures or business startup costs. The less you pay for financing, the more affordable those things are. And yes, you can use home equity to consolidate more expensive debt, IF you are disciplined enough to change spending habits and to repay the home equity loan as quickly as possible.