Building equity in your home comes with many advantages. Among the most useful financial advantages is being able to take out a home equity loan, also known as a second mortgage or term loan. With this type of loan, a mortgage lender lets you borrow money against the equity in your home. The money is given in one lump sum with a fixed rate usually lasting five to fifteen years. You pay off the loan on a monthly basis on top of the mortgage you already pay.
Because you’re using the equity in your home as collateral, you could lose your house if you default on payment. Also, this type of loan reduces the equity you have in your home, so when you sell your house, you’ll need to pay off both mortgages with your sale proceeds.
Because there’s risk of losing your home if you default on the loan, it’s important to know when it makes sense to use a home equity loan and when it doesn’t. Check out the best and worst lists.
Best Reasons to Use a Home Equity Loan
Debt Consolidation. With credit cards charging astronomical interest rates, sometimes upwards of 20 percent, it makes sense to consolidate debt at a much lower rate with a home equity loan. If you have debt from multiple high-interest credit cards, consolidation makes perfect sense as you can save thousands of dollars. Just beware that your continued spending discipline is required. If you go back to racking up more debt on your credit cards again, you’ll find yourself in worse shape.
Home Updates and Improvements. One of the best uses of a home equity loan is for projects that help improve the value of your home over the long term. Short term projects such as installing a new roof or renovating a kitchen or bath are sensible reasons to use a home equity loan. Be aware that it might make more sense to get a HELOC (home equity line of credit) for longer-term ongoing home renovation, which works more like a credit card that you only use as you need it.
Starting a New Business. A home equity loan can be a great way to fund a new business. But be certain that you’ll have a way to pay off the loan if your new business doesn’t succeed. If you’re already stretched financially, you might not want to take on the additional risk to your home.
Worst Reasons to Use a Home Equity Loan
A New Car. Start with your bank or credit union for an auto loan. You can find comparable interest rates without having to use your house as collateral.
Paying for a Lifestyle. Your home equity isn’t a bottomless piggy bank. Obviously loans need to be paid off, so using your home as collateral to fund a particular lifestyle doesn’t make financial sense. You’re better off finding ways to increase your income to fund a more expensive lifestyle.
Paying for Basic Expenses. Things like groceries, clothing, cable, and utilities should be a part of your household budget. If you need a loan to pay for these items, it’s probably time to figure out a new budget and cut costs. You’ll only dig yourself deeper in debt if you can’t afford basic expenses.
Financing College for Your Kids. Using a home equity loan to pay large tuition bills can work, but only if you have a solid plan in place (and the income) to pay it off. Most people with college age children don’t want to delay retirement by taking on large additional debt. If you weren’t able to save enough for your children’s college over the years, you may want to help them look at taking out their own student loans.