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Avoid Using a Home Equity Loan for These 5 Things
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If you need cash, you might be thinking about tapping into your home equity. In some cases, this can be a great alternative to a personal loan — but exercise extreme caution when putting your home on the line.
Here’s a guide to borrowing against your home and when it should never be done.
How to tap into your home’s equity
Home equity is simply the difference between how much a home is worth and the outstanding loans on the property. About one in four U.S. properties with a mortgage is considered equity rich, meaning loans on the property amount to 50% or less of its market value, according to a report from ATTOM Data Solutions.
If you’re in that category, here are the three most common options you have to access that value.
1. Home equity loan
Also known as a second mortgage, a home equity loan gives borrowers a lump sum that’s paid back over a period of time. Interest rates are typically fixed, so you know exactly how much to budget for each payment for the life of the loan. Borrowing against your mortgage with a home equity loan is usually cheaper than getting access to cash with a personal loan or credit card because you’re using your home as collateral, lowering the risk to the lender.
However, a home equity loan comes with closing costs and fees. And you take on significant risk: If you fail to make payments, you could lose your home.
A home equity line of credit offers the flexibility to borrow money when you need it. Like a credit card, you’re able to choose how much to borrow at a time and when you access funds. Unlike a credit card, your home is used as collateral — and failure to make payments on schedule can result in foreclosure.
Your lender will set a maximum amount you can borrow at a time. Payments don’t start until you actually use the money, and then you’ll pay back principal and interest each month. Most HELOCs are typically attached to an adjustable-interest rate, so if interest rates rise, your payments will, too. Always read the fine print, because HELOCs often come with fees and penalties.
3. Cash-out refinance
Effectively replacing your current mortgage, a cash-out refinance issues you a new loan for an amount higher than your existing mortgage. The money is used to pay off your existing home loan, and then the amount left over is distributed to you in cash. Your new mortgage might carry an interest rate and terms that differ from your current mortgage. A cash-out refinance could lengthen the term of your loan and it will come with closing costs and fees.
When not to use a home equity loan
Home equity loans are useful but should be used with caution, said Krista Cavalieri, owner and lead advisor at Evolve Capital, a fee-only financial firm in Columbus, Ohio.
Much like a credit card, “Purchases should be thoughtful and a plan to pay the debt should be in place,” she said.
Not everybody follows those guidelines. Here are five types of purchases where a home equity loan could get you into trouble.
Home equity should not be used to supplement your lifestyle. Tapping into your home equity to fund shopping sprees, dinners, nights on the town or televisions is not a good idea, Cavalieri said.
“It may seem silly, but I have certainly seen this before,” she said. “It is still a form of debt and needs to be treated as such.”
Using home equity to fund vacations with no plan in place to pay the debt is just as dangerous as frivolous spending, she said. It’s especially risky because there is no guarantee your home will continue to be worth its current value.
“This is part of what contributed to the crisis in 2008,” Cavalieri said. “People used their homes like ATMs, believing the value would always increase.”
An investment with unrealistic claims
If you’re offered the opportunity to invest in something with a promise to double your money in three years, watch out. This is not a good use of home equity, said Grant Glenn, managing partner and individual wealth strategist at Noble Wealth Partners, a fee-only wealth management boutique firm in Denver.
Even if an investor is promising guaranteed returns, it’s certainly not a sure thing. If you use an equity loan and the investment goes sour, you could lose your home.
Buying a car
In most cases, using home equity to purchase a new car is not a good idea, Glenn said. Generally speaking, it’s not wise to put your home on the line for a car. Plus, the interest rate you’ll get on a home equity loan is generally higher than what a borrower with good credit will get on an auto loan.
However, there could be exceptions to this rule. If someone needed to buy a new car to
earn money as an Uber driver, that could be a different story, Glenn said — but it’s a long shot.
Paying for college
While it may seem like a good idea to use home equity to pay for your education or your children’s, Cavalieri said there are likely better funding options available, such as direct loans, where the U.S. Department of Education serves as your lender. This also includes scholarships and merit aid.
Still, this is a common use for equity borrowing. Educational expenses were cited as one of the top three uses for home equity lines of credit in a 2017 survey conducted by TD Bank. Of homeowners with existing HELOCs, 12% said the money was being used for education.
Starting a business
If you’re like many Americans, you might dream of being your own boss. A home equity loan could come with less red tape than getting approved for a business loan, but taking this path might not end well.
Only 50% of businesses with employees make it past the five-year mark. Hopefully, your company would be in the prevailing half. But if it isn’t, you’ll be out the money you borrowed — and possibly your home.
Better uses for home equity loans
Here are a few cases where tapping into a home equity loan is more likely to make sense.
Because home equity loans typically carry lower interest rates than other financial products, they can be a good option to consolidate other debt you have.
If you’re paying down excessive credit card debt or other debt with a sky-high interest rate, tapping your equity can be a wise move, Glenn said.
“It can be difficult to pay down the principal on credit cards when the interest alone stretches your budget past your means,” Glenn said. “Sometimes it is necessary to use a home equity line to get your head above water.”
But it’s not a permanent solution, particularly when your home is at risk.
“There should still be a plan in place to pay down this debt,” Cavalieri said.
If you use the proceeds of an equity loan to renovate, expand or otherwise fix up your home, you can immediately start adding back the equity you drew upon.
This can also give you tax advantages. Under current tax law, you can generally only deduct interest paid on home equity loans if the money goes toward home improvements.
Using home equity for improvements can be a good option especially if you’re planning to sell your home soon, Glenn said. If you’re not, he advises you to consider it carefully.
“As a planner, I would not want a client to take on debt, so they could simply have a new kitchen,” Glenn said.
If you need cash in a pinch, tapping into your home equity can be a wise move in some cases, Cavalieri said.
For example, you might have an urgent car repair but not enough cash to pay for it. A home equity line of credit can work well if you know you’ll be able to pay down the balance in a few months, she said.
Buying an investment property
Buying a home that you’ll then rent out can add an income stream for your family.
For some people, taking out a home equity loan to do so is a good idea, but it’s not for everyone. Your unique financial situation and the terms of your financing will determine whether it’s right for you, financial planners say.
Paying for a major life event
If you need cash to pay for a major life event like a wedding, a home equity loan might be a way to do so.
Since the loan is secured by your home, you’ll likely get a lower rate than with a personal loan or credit card. But of course, if you default on the loan, you could lose your home.