At some point in your financial life, you may want to leverage your home equity to improve your financial position. You might get a home equity loan, which gives you a specific amount of cash; or sign up for a home equity line of credit (HELOC), which provides ready access to cash as needed. Both carry attractive tax benefits associated with interest expense deductions as well as risk associated with using your home as collateral.
You definitely want to avoid taking on too much debt and using home equity for fleeting expenses. But there are times when an equity-based loan makes sense. Consider these proper uses of home equity loans and HELOCs:
1. Home renovations
One of the most common uses of a home equity loan is the funding of a major home renovation, which can boost the value of your home. Even though you are increasing your debt, your loan-to-value ratio may remain stable as you upgrade your home and increase its value.
The construction of an extra bathroom or a new bedroom, for example, could be financed with a home equity loan. But don’t confuse renovations with routine repairs and maintenance, such as roof replacements or HVAC maintenance. Save 1-3% of your home’s value annually for ongoing expenses and borrow for major projects if needed.
2. Debt consolidation
About 40% of home equity loans or HELOCs are used for debt consolidation. In these situations, homeowners pay off high-interest loans (such as credit card balances) with an equity-based loan at a much lower rate. As a result, borrowers are able to settle outstanding debt while minimizing monthly payments, generating cash flow to fund savings, education, and retirement accounts.
Be cautious about freeing up card limits only to max them out again. Before consolidating debt into a home equity loan or HELOC, reduce household expenses and change financial habits so that you’ll easily pay off outstanding loans without incurring new ones.
3. Vehicle or equipment purchases
Purchasing an asset that generates income or allows you to make money (such as a car for commuting) can be an appropriate use of home equity borrowing. Fund the purchase of a car, truck, or large piece of equipment with a home equity loan or HELOC. You may be able to get an interest rate that is lower than dealer financing plus deduct interest charges from your taxes.
Match the expected useful life of the vehicle or equipment in number of years (or less) with the term of the loan. And, don’t buy the bigger or more loaded vehicle just because you are getting a lower interest rate. Use the home equity loan to save money, not to spend more.
4. Rental property investments
If you are a current or potential landlord and want to purchase, improve, or repair rental properties, you might borrow against your real estate holdings. Consider getting an equity-based loan using your primary residence as collateral.
A home equity loan with a fixed rate and term may be ideal for a purchase or making specific renovations to rental properties. A HELOC may be more suitable for non-recurring expenses that may arise as you develop a base of rental clients and stabilize cash flow associated with rental operations.
5. Vacation home
Borrow against your current home to make a down payment on the purchase of a vacation home in order to expand your real estate portfolio. Talk with your banker to determine the most appropriate way to tap equity to fund the purchase of a second home. Consider the tax implications of borrowing costs and potential income from rentals.
Before borrowing against your home equity, compare loan or credit line structures, costs, and benefits of various options. Consider upfront and annual fees; annual interest charges and corresponding eligibility for tax deductions; total interest charges, which may be more on lower-rate, longer-term loans than higher-rate, shorter-term ones; and whether interest rates are fixed or variable. Run the numbers and work with lenders to get the best deal that fits your needs.