Home equity lines of credit are an awesome financial product, but they don't come without their own set of specific risks. To use your home equity line of credit without regret, first read these six worst ways to use your loan before your write that check.
1. Paying for a vacation The first mistake is using your home equity line of credit to live above your means. That can be paying for a vacation, using it to support going out to eat, buying luxury goods, or more generally, spending what you don't have.
This risk is very similar to the risk of running up too much credit card debt, except that making this mistake with your home equity line of credit affects more than just your credit rating: It puts your home at risk.
Home equity lines of credit are structured as a hybrid of sorts between the standard mortgage loan and credit cards. Home equity lines of credit are secured by your home, which lowers the risk for the bank and allows them to offer you a low interest rate, similar to a mortgage. Home equity lines of credit are lines of credit though, like a credit card. You can draw from your line of credit and either leave a balance outstanding or pay it off immediately. Because of the lower interest rate, there are times when leaving a balance on your home equity line of credit is acceptable, but generally it's better to pay off any line of credit as its used.
Running up living expenses, paying for vacations, or buying that ski boat you've always wanted may seem reasonable because of a home equity line of credit's low interest rate. However, the structure of the loan is such that it's just like buying these items with a credit card. In other words -- don't do it.
2. Buying a car Many times, the interest rate a bank offers you for an auto loan will be higher than the interest rate available to you on your home equity line of credit. That may be true, however, there are important differences between a home equity line of credit and an auto loan that make the auto loan the better choice despite the higher interest rate.
First, the auto loan is secured by the vehicle, not your home. If you fall on hard times, the worst case scenario of the auto loan is that you lose the vehicle. The worst case for the home equity line of credit is your lose your house, which far more valuable asset.
Second, a car is a depreciating asset. Its value will decline over time, whether you like it or not. Therefore, it's absolutely critical that you pay down any debt on the car quickly to avoid having negative equity. An auto loan is structured so that each payment pays both interest and principal, guaranteeing that you do in fact pay down the debt quickly. Most home equity line of credits don't require you to pay the full principal and interest with every payment, and if they do, the repayment period is typically much longer than the useful life of the car.
So, unless you have the discipline to pay down your home equity line of credit above the minimum payment to pay off the debt from the car purchase in three to four years, then you're probably better off taking the car loan.
3. Paying for a child's college tuition For largely the same reasons as above, it's generally wise to avoid paying for a college education with your home equity line of credit. Again, any unforeseen cash flow troubles in the future will put your home at risk with the home equity line of credit, while a student loan will generally be unsecured and pose no risk to your home.
Likewise, the student loan option will be structured as an installment loan with required principal and interest payments. Unless you have the discipline to regularly pay down your home equity line of credit within five to 10 years, the installment loan structure is the better way to go.
Another consideration is the implications for parents approaching retirement age. If the college bill is substantial, the added debt on the home could prevent downsizing and unlocking the equity in your home to aid in your retirement. In this case, it may be a better decision to have your child take out student loans rather than further encumber your house with a high home equity line of credit balance.
4. Paying off credit card debt For many, the option to consolidate credit card debt with a home equity line of credit seems like a no-brainer. Unfortunately, the cost of that decision oftentimes ends up being far greater than any cash saved with the lower interest rate of the home equity line of credit.
Before proceeding with this plan, ask yourself how you got into credit card debt to begin with. If it's because you have a hard time sticking to your budget (see mistake No. 1 above), then using your home equity line of credit to consolidate credit cards could be a big mistake. With continued overspending, you'll find yourself in the exact same position in a few years, but without the equity in your home to bail you out.
Remember, if you can't repay your home equity line of credit, the bank can foreclose on your home. Instead of taking that risk, try to refinance your credit cards into a stand-alone installment loan with regular principal and interest payments. Banks, credit unions, and alternative lenders online all have specific products designed for exactly this product. These loans will pay off your debt quickly and won't put your home at risk. (And while you're at it, cut up those credit cards.)
5. Investing in the stock market The argument to use a home equity line of credit to invest in the stock market typically goes something like this: Borrow money from the home equity line of credit at a low interest rate, say 4%. Invest that cash in the market and earn something like 8% per year. Then, like magic, you make 4% on your money with no other effort!
The reality doesn't always work out that way. Predicting what the stock market is going to do over the next few months or even few years is a futile effort. The market could rise as you hoped it would, or it could decline rapidly, wiping out your position and leaving you on the hook to the bank for the full amount you borrowed.
Over the long term, the stock market has risen more than it has fallen. If you have the discipline to buy and hold for the long term, there's another consideration that could derail your plan: your home equity line of credit has a required monthly payment. Depending on your specific loan, that payment may be interest only or it may be interest along with a small amount of principal. In either case, you will have to come up with the cash to pay that monthly requirement even though the money you borrowed is invested in a stock that only pays you through appreciation and perhaps the occasional dividend.
If you wish to use debt to invest in the market, consider instead opening a margin account with your brokerage. These accounts are risky in their own right, but at least you won't have to put up your house as collateral.
6. Speculating in real estate In the years before the financial crisis, many people cashed in their home equity lines of credit to buy speculative real estate investments. Some bought properties outright, others used their home equity line of credit to fund down payments and then took out even more debt to buy these so-called investments.
At this point, we are all familiar with how these speculative bets payed off after the market crashed.
Even in a stable real estate market, speculating on land or attempting to buy and flip homes is a very risky business. Unforeseen expenses (there are always unexpected costs in renovations), finicky buyers, and inexperience can combine to sink the investment, leaving you underwater on the property and up to your neck in debt.
While these real estate lessons may be obvious today, the point applies more generally. A home equity line of credit is a poor tool to use to speculate, even when you're supremely confident the bet will work out. That applies to real estate, the stock market, or any other hot investing fad of the moment. Yes, the interest rate may be low and the cash easy to access, but is it really worth putting your house on the line for such an uncertain outcome?
Used responsibly, home equity lines of credit are a great tool All of these mistakes have a lot in common. None increase the value of your home. Each pose a significant risk of erasing the equity you've built up in your home. None match the use of the cash with the asset it is secured by.
Avoid these mistakes and your home equity line of credit can be a great tool in your financial toolbox. Use your home equity line of credit to increase the value of your home. Keep it with a zero balance, saving it for an emergency when you really do need access to cash quickly. If you do use it to purchase something, force yourself to pay down the debt as quickly as you can. Do that, and you can comfortably take advantage of your home equity line of credit's low rate without worrying about putting your home at risk.
The article 6 Terrible Uses for Your Home Equity Line of Credit originally appeared on Fool.com.
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