Home Equity Loans: What To Do & What Not To Do
Home Buying & Improvement
Take Advantage of HELOC's Power
A home equity line of credit (HELOC) is like having a credit card that's secured by the value of your home. Like a credit card, home equity loans have a credit limit. That limit is usually determined at the time you open the account according to the value of your house and what is still owed on the first mortgage.
What is Equity?
Equity is the value of your property minus the debts that are held against it. If you pay down your mortgage by $500, you have an additional $500 worth of equity in your home (assuming the value isn't less than what you owe on your mortgage).
Building equity is one of the best arguments for owning a home as opposed to renting one. The money you pay monthly toward your mortgage is still yours and you get it back when you sell the house. If you need cash but don't want to sell your home, one option is a home equity line of credit.
A home equity line of credit (sometimes shortened to 'HELOC') is like having a credit card that's secured by the value of your home. Like a credit card, home equity loans have a credit limit. That limit is usually determined at the time you open the account according to the value of your house and what is still owed on the first mortgage.
Home equity lines of credit are typically good for a specific term, generally 10 to 15 years, and sometimes have a 'draw period' that allows you to take money on the loan over time, rather than at once.
The most important benefit of using this line of credit is that the interest is usually tax-deductible.1 The risk, is that failure to repay could result in foreclosure. To avoid that, consider some common mistakes people make with home equity lines of credit as well as some low-risk opportunities they can provide if managed responsibly.
Do: Improve Your Home
One of the safest investments you can make with a home equity line of credit is remodeling or improving your home. Installing new appliances, vinyl siding, or energy efficient windows will pay dividends both in the increased value of your house and in your quality of life. The money you've put into your home may pay off when you sell it.
Don't: Think of it as "Free Money"
One of the key causes of the sub-prime mortgage crisis was abuse of home equity loans. People would spend recklessly using the equity in their homes. They expected the value of their property to forever keep pace with their level of spending. When it didn't, they found themselves owing more money on their homes than they were worth, and there was not enough credit (or value) in the home to refinance. Spending your home equity to finance your lifestyle is a lot like burning your house down to stay warm in the winter. It'll work for a while, but you'll be left without a place to live.
Do: Think of it as an Emergency Fund
One of the smart money habits of financially successful people is establishing a small pool of savings to pay for unexpected disasters like job loss, car repairs or major illness. Having this savings enables them to avoid going too heavily into debt if one of these catastrophes occurs. You can use your home equity line of credit in a similar way. While it's not an ideal emergency fund, it's a far better rainy day answer than credit cards, payday loans or car title loans.
Don't: Use it to Pay for Vacations, Basic Expenses, or Luxury Items
You have worked hard to create the equity you have in your home. Avoid using it on anything that doesn't help improve your financial position in the long run. Never use your home equity line of credit to pay for basic expenses like clothing, groceries, utilities or insurance. And, as much as we all need that vacation, you are better off saving for it than paying for it with the equity in your home. Likewise, avoid using you home equity line of credit on luxury items that will lose their value as soon as you bring them home.
Do: Use it to Start a Business
If you've been thinking about opening a small business, you probably already know that financing that dream can be a struggle. Your home equity line of credit can help pay for some of your start-up expenses. You can use it in conjunction with grants and small business loans to diversify your risk. The favorable, flexible repayment terms and lower interest rates can make this a viable option for your new venture.
Check with your tax advisor regarding your tax deductibility.
