Buying a home can be a great way to grow your net worth over time, and one benefit of homeownership is using the equity you build to finance a major expense. Not all big expenses should be financed with a home equity loan, however, and there are important risks to consider before tapping into your home equity.
How home equity loans work
There are two common types of loans homeowners use. A home equity loan has a fixed-interest rate and provides a lump sum of cash up front. A home equity line of credit, or HELOC, has a variable interest rate and works more like a credit card in that you can make repeated withdrawals over time. Both are secured by borrowing against your home equity, which means your home is the collateral. This is hugely significant because if you default on the loan, your bank or lender can repossess the property.
Risks of borrowing against home equity
There are plenty of prudent reasons to draw on home equity – financing a home renovation, for example. Ideally, your equity can be leveraged into a project or enterprise with an eventual return or payoff such as increasing the value of your home or paying for college tuition.
“Many people with so much equity in their home think that they should put it to work,” says Lawrence Pon, certified public accountant and owner of Pon & Associates. “Debt is debt. It has to be repaid and it comes with a cost. It is not free.”
But a one-time expense, such as a wedding or a vacation, is not an optimal use of home equity – however important it may seem in the moment. Here are some common big-ticket expenses that you should think twice about financing through a home equity loan.
A wedding is a milestone life event, but it can come with a hefty price tag. The average US wedding costs almost $30,000, according to The Knot, which could tempt one to draw on home equity. But leveraging your largest asset for a single day, regardless of its significance, is not the best use of a home equity loan or HELOC.
A second home
Although some lenders will approve you for a home equity loan or HELOC to finance a down payment on a second home, doing so will net you three mortgage payments per month, which could be a squeeze. And if home values decline, the value of your investment may contract, leaving you stuck with a loan to pay back and underwater on your asset. Experts recommend against risking the loss of a primary residence for a secondary property.
Starting a business
Even seasoned entrepreneurs have a high rate of failure when it comes to starting a business. Putting your home on the line to fund a startup is a very risky financial move – especially when interest rates are increasing and there’s a potential recession around the corner.
Taking a once-in-a-lifetime vacation may be a tempting use of funds, but using your home as collateral to travel isn’t a strategic use of home equity. A home is many people’s most valuable asset. Risking it for two weeks of fun isn’t a sensible tradeoff.
A car is a depreciating asset that only loses value over time, making it among the worst uses of home equity. And if you have a high enough credit score to qualify for a home equity loan, you’re likely to qualify for an auto loan or personal loan – neither of which will require you to put your house on the line.
The bottom line
The intended purpose of a home equity loan is typically for home renovations or improvements that will increase the value of your property, and they should only be used to finance different kinds of life expenses if other types of financing aren’t available to you. When you put up your home as collateral to secure a loan, you are potentially risking foreclosure if you miss payments, so if you can obtain financing through other means, it’s worth doing so to avoid jeopardizing the roof over your head.