Home Equity Loans Revealed
Like any other form of credit, a home equity loan, sometimes called a home equity mortgage, can be a smart and practical way to pay off high-interest credit card debt and other expenses. Since home equity loan rates tend to be far more reasonable than those of other lines of credit, if you use a home equity loan responsibly, you can use the equity you've built up in your home to enhance its value like a home improvement loan. However, since your home is probably your single biggest asset, you should be very careful about how and when you use this resource, or you risk losing it.
When it makes good financial sense to take out a home equity loan
If you have a steady job and a reliable source of income, and you're certain that you'll be able to pay off the home equity mortgage on time, borrowing against your home's equity can be a wise move. Home equity loans are tax-deductible, and home equity loan rates are far lower than other sources of credit. If you use this money to pay off high-interest credit card debt, use it for large home repair bills, or apply it to unforeseen expenses such as medical bills, this is smart money management. In fact, the majority of people who take out home equity loans use them to pay off credit card debt.
When home equity loans are a bad idea
Borrowing against your home always carries a bit of risk even under the best of circumstances, but here are some examples of when it should be avoided altogether.
- Using the money for investments. Even though a stock or other investment looks like a sure thing, using your home's equity for anything that has the slightest chance of losing money is perilous at best. The stock-market plunge in the fall of 2008 should serve as a cautionary tale against counting on investment returns.
- Using the money to buy a car. If your car dies and you're in a tight financial spot, this is tempting, but you may still be paying it off after the car's useful life is over.
- When the loan exceeds the home's value. Some home equity loans are structured to let the borrower borrow up to 125% of the home's value. This is a lousy proposition for the homeowner, because it's not tax-deductible and will only benefit the lender.
- When you use the money for a want, not a need. Using a home equity loan for costly repairs — a new roof, a new furnace, extensive plumbing or electrical work — is a need and a practical use of the money. But if you plan to use the money for wants, such as a swimming pool, a three-season porch, or a home spa, you're better off putting some money aside each month and saving for it.
As stated previously, you should always be very careful about how, when, and why you take out a home equity loan, because your home is your single biggest asset. If you're unable to pay off the home equity mortgage for some reason, you could lose your home, and your credit score would take a huge hit from the default. Before signing any home equity loan documentation, sit down and soberly assess whether this line of credit makes sense from a financial and practical standpoint.
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