When Home Equity Loans or Lines of Credit Can Lead to Trouble

Use your home equity loan or line of credit wisely -- here's how.

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Many homeowners have a home equity loan or line of credit but don't know the best way to use it. Using home equity can be smart in certain circumstances, and not so smart in others. 

What is home equity? Your home equity is the difference between the value of your home and your mortgage balance. With a home equity loan or line of credit, you use this equity as collateral in order to get the loan. (To learn more about home equity loans and lines of credit in general, including how to get one, read Nolo's article Home Equity Loan Basics.)

With the current financial crisis, you may have heard experts advising getting a loan or line of credit even if you don't need the money now. However, it's wise to use caution when using a home equity loan or line of credit, given that:

  • Like any loan, you'll pay fees and interest.
  • Your home is collateral for the loan, so if you default on the loan, you could lose your home.
  • By its very nature, a home equity loan depletes equity in your home.

Here are some of the best ways to use your home equity for a loan or line of credit.

Emergencies

Traditionally, financial experts have advised homeowners to open a home equity line of credit for use in emergencies. This strategy is especially helpful for those concerned about losing their jobs. Because the lender must document your income before giving you a line of credit, if you wait until you are unemployed to apply, the lender will most likely reject your application.

New advice for hard financial times. In these shaky times, some experts advise that homeowners actually take money out of their line of credit, or get a home equity loan, even before they need the cash. This is because in the past, as long as you had equity in your home, you could draw on it in the form of a loan or line of credit. But with today's flat and falling home prices, some risk-adverse lenders are turning off the tap on home equity loans. That might mean you can't get a home equity loan or line, or that your existing home equity line of credit will be reduced, or eliminated altogether.

If you take out money ahead of time, you can use the cash to consolidate other bills like credit card bills -- provided you cut up all the credit cards and actually close the accounts. This can also give you some financial breathing room in hard times.

The more conservative approach. Not all experts advocate the "use it or lose it" school of thought. The most conservative advice suggests you should leave your home equity in place. If in doubt about what's best for you, consider talking to a trusted financial advisor.

Capital Investment

Both conservative and more liberal financial experts agree, if you've got equity to use and don't need to hold onto it as a safety net, the best way to use it is as a prudent capital investment. Some examples include:

  • home improvements with high value returns
  • education for the kids
  • financing a sound business plan, and
  • other financial moves that have a good chance of providing an equal or better return on your money than the cost of the loan.

Real Estate Investment

Today, lower home prices make buying another home or real estate investment property a potentially sound capital investment, but only over the long haul (more than five or ten years). If you use a home equity loan to buy real estate, be sure that rental income will offset all or most of your carrying costs or that you have other means to carry the investment risk until it pays off.

Unwise Use of Home Equity

Experts agree that you should not use home equity to buy luxury items like big gas guzzling cars, boats, RVs, vacations, home theaters, and other items that don't give you a return on your money.

Using equity money to make monthly payments on the equity loan itself, other debts, utility payments, and small household bills, is often a sign of financial distress. The same is true if you use equity money to buy consumables such as groceries, gasoline, clothing, and similar essentials. If your income doesn't cover those items, your household budget isn't balanced and it's time to seek financial counseling. (For help in finding a good financial counselor, read Nolo's article Choosing a Credit Counseling Agency.)

To learn more about making smart decisions in relation to the real estate you own, get The Essential Guide for First-Time Homeowners: Maximize Your Investment & Enjoy Your New Home, by Ilona Bray and Alayna Schroeder (Nolo).

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