If you need cash for a major expense, your bank account can’t always cover it. But if you’ve accumulated equity in your home, whether by putting down a large down payment or by making monthly mortgage payments over a long period, you can borrow against your property. A home equity loan means you can secure the funds now versus waiting until you’ve saved enough.
Don’t let the ease of accessing that cash fool you, though. Home equity loans and home equity lines of credit come with serious risks, and they aren’t right for every scenario.
How home equity loans work
Home equity is the difference between how much you owe your mortgage lender versus how much your home is currently worth. So, if your outstanding principal loan balance is $200,000 and your home value is $450,000, you have $250,000 of equity, which means around a 55% ownership stake in your property.
There are two common types of home equity loans. A home equity loan has a fixed interest rate and provides a lump sum of cash upfront. A home equity line of credit, or HELOC, has a variable interest rate and works more like a credit card in that you can make repeated withdrawals over time. But you can’t borrow against all your equity. With either type of loan, your lender will want you to maintain a sizable chunk of equity – often 15% to 20%.
Both home equity loans and HELOCs are secured by borrowing against your home equity, which means your home acts as collateral for the loan. This is hugely significant because if you default on the loan, your bank or lender can repossess the property.
When a home equity loan doesn’t make sense
No matter how important some purchases seem, using your home as collateral to pay for nonessential expenses isn’t a good idea. A one-time expense, such as a wedding or vacation, isn’t optimal for a home equity loan. Here are some common expenses you shouldn’t finance through a home equity loan.
Weddings
A wedding is a milestone event that can come with a hefty price tag: The average US wedding costs almost $30,000, according to The Knot. However, leveraging your largest asset to cover a wedding for a single day isn’t the best use of a home equity loan or HELOC. Since finances are usually one of the biggest challenges in married life, perhaps you’re better off ditching a loan altogether, heading to the courthouse and avoiding the stress of having debt down the road.
A second home
Although some lenders will approve you for a home equity loan or HELOC to finance a down payment on a second home, doing so will net you three mortgage payments per month, which could be a squeeze. And if home values decline, the value of your investment may contract, leaving you stuck with a loan to pay back while being underwater on your asset. Experts recommend against risking the loss of a primary residence for a secondary property.
Starting a business
Even seasoned entrepreneurs have a high rate of failure when it comes to starting a business. Putting your home on the line to fund a startup is a very risky financial move. Interest rates may be poised to decline, but the “soft landing” that the Fed has hoped for isn’t a sure bet. According to J.P. Morgan, economic growth is likely to decelerate in 2024, meaning even the best business idea could flop.
Vacations
Taking a once-in-a-lifetime vacation may be a tempting use of funds, but using your home as collateral to travel isn’t a strategic use of home equity. A home is many people’s most valuable asset, and risking it for two weeks of fun or relaxation isn’t a sensible trade-off. Make a plan to save for that getaway, even if it means delaying your plans to avoid debt.
Cars
A car is a depreciating asset that only loses value over time, making it among the worst uses of home equity. And if you have a high enough credit score to qualify for a home equity loan, you’re likely to qualify for an auto loan or personal loan – neither of which will require you to put your house on the line.
When a home equity loan makes sense
Now that you know when you should not use a home equity loan, here’s a rundown of when it does make sense.
Home improvements or repairs
A home equity loan or a HELOC is a smart route if you want to finish your basement or renovate your kitchen. You’ll be boosting your home’s value and improving your time living there. Plus, those improvements and upgrades can positively impact your tax bill: The IRS says that interest on home equity borrowing is tax deductible if you’re using the funds to “buy, build or substantially improve your home.”
Consolidate high-interest debt
If you’ve been struggling to pay off past debts such as credit cards, private student loans or personal loans, a home equity loan can deliver two positive benefits. You’ll likely score a significantly lower interest rate with a home equity loan, which will save on interest. And if you’re juggling multiple payments from multiple lenders, a home equity loan can help you pay them off and streamline your payment to just one source with one due date.
Cover emergency medical expenses
Life happens, and unfortunately, life can include some overwhelming scenarios, such as receiving large bills for medical procedures. If you’re in a situation that requires more funds than your insurance will offer, a home equity loan can help reduce some of your stress and get you or your loved ones essential care.
How to use a home equity loan
If you’re going to use a home equity loan or HELOC, follow these tips.
Make a budget
Avoid borrowing more than you need. For example, if you’re using a home equity loan to expand your home, sit down with your contractor to chart your overall cost expectations. You’ll want to budget just a bit extra for the potential overage costs, but taking on more debt is never a good idea.
Look for discounts
Some lenders offer lower interest rates, so read the fine print or ask how to get your rate down. For example, some banks might reduce the rate on HELOCs by a fraction of a percent simply by enabling autopay. Be sure to explore all potential opportunities to reduce your expenses.
Be realistic about your spending impact
If you’re using the funds to upgrade your property, make a realistic assessment of its appreciation once the project is complete. Most home projects fail to deliver a dollar-for-dollar impact, meaning that a buyer down the road isn’t going to pay you exactly what you invest in a new kitchen.
Alternatives to a home equity loan
If you’re comparing alternative options for financing, you’ll likely consider credit cards, which can make sense in certain scenarios. For example, if you’re planning a relatively small home project, you could use a credit card with a 0% APR introductory period, as long as you plan to pay that bill before the regular APR kicks in. You’re on the hook for some staggeringly high-cost debt if you don’t.
For bigger borrowing needs, there are three other main alternatives:
Cash-out refinance
Instead of taking a second mortgage with a home equity loan, a cash-out refi replaces your existing mortgage with a bigger loan (that’s the “cash” part). A cash-out refinance can make sense if you can score a lower rate than you have on your current mortgage. However, there are various factors to consider, including closing costs and the timeline. With HELOCs, you could receive the funds in less than a week if you qualify. A cash-out refinance, on the other hand, is similar to applying for your first mortgage: You’ll typically need to wait 30 to 60 days to officially close on the loan.
Personal loan
The biggest upside of a personal loan is the safety — you aren’t putting your home up as collateral. However, lenders typically charge higher interest rates for personal loans because they come with greater risks for them. (They can’t take your house if you don’t make payments.) Nonetheless, if you have excellent credit and your borrowing needs are relatively small — think less than $100,000 — the best personal loans can be a good fit for your finances.
Reverse mortgage
If you’re 62 or older, a reverse mortgage is worth a look. You’re still tapping your available equity, but you don’t need to worry about paying it back until you move out, sell the home or pass away. These aren’t simple products, and you’ll need to talk to your spouse and/or heirs about the pros and cons. However, these can be helpful for accessing liquid cash to make sure you are comfortable in your later years.
The bottom line
Home equity borrowing has been on the rise over the past two years. In fact, data from the Federal Reserve Bank of New York shows that HELOC balances increased by $9 billion in the third quarter of 2023. If you’re thinking about opening a HELOC and adding to that balance in 2024, just remember that you’re putting the roof over your head on the line. Whatever you’re paying for needs to be worth the risk.
