A home equity loan can be an easy way to cheaply access cash, but it can come at a high cost. Borrowing against your home’s equity risks your home and prevents you from building wealth over the long term. Just like with a home equity line of credit (HELOC), taking out a home equity loan for anything that won’t directly increase your home’s value is usually not recommended. These are the top things for which you should never use your home equity loan.
- A home equity loan risks your home and erodes your net worth.
- Don’t take out a home equity loan to consolidate debt without addressing the behavior that created the debt.
- Don’t use home equity to fund a lifestyle your income doesn’t support.
- Don’t take out a home equity loan to pay for college or buy a car.
- Don’t take out a home equity loan to invest.
Paying Off Debt Without a Plan in Place
Home equity loans have much cheaper interest rates than other forms of unsecured debt such as credit cards because they use the equity you have in your home as collateral. It can be very tempting to consolidate a large balance of high-interest debt into a lower-interest-rate home equity loan.
"Remember that with a home equity loan, you are putting a second mortgage on your home. You should only do that when you either have no choice or it makes good financial sense."
—Kimberly Foss, founder and president, Empyrion Wealth Management
Taking out more debt to pay off existing debt can make good financial sense, but only if you have a good plan in place. If you don’t address the spending habits that got you into debt in the first place or don’t actually use your home equity loan to pay off your debt, you’ll find yourself in a much worse situation overall. If unpaid, credit card debt can tank your credit—but an unpaid home equity loan will lead to foreclosure and possibly losing your home. Don’t risk it if you don’t have the discipline or ability to pay it off.
Funding a Lavish Lifestyle
Using a home equity loan to finance a lifestyle your regular income can’t sustain is very unwise. Going on a dream vacation, eating at nice restaurants with your friends, or keeping up appearances among a successful social circle all sound nice, but you’re risking your home by using home equity to buy them. If taking out a home equity loan is the only way to finance your dream wedding, you need to reassess your dream and go with something more modest, increase your income, or delay until you have the cash saved to do it.
Paying for College
Taking out a home equity loan to pay for college risks your own home to pay for a degree that may not ever be finished or utilized. If you have college-aged children, you are most likely within your last few working years before retirement. In that case, taking on a large debt like a home equity loan can delay your own retirement. Look into other college funding options before taking out a home equity loan.
Buying a Car
You should never take out a home equity loan to buy a car. Auto loan interest rates are rising higher than home equity loan rates, and an auto loan doesn’t erode your home’s equity or risk foreclosure if you can’t pay it back.
Using a home equity loan to invest should be avoided. “Home equity should never be accessed for speculative purposes, including the purchase of real estate, because if the market goes against you, you could lose the value you’ve built up in your home,” says Kimberly Foss, founder and president of Empyrion Wealth Management.
Though some expert real estate investors and stock market speculators have risen to fame over the past several years making millions by leveraging their home’s equity, they are the exception, not the rule. Don’t risk your own home for an investment that could go to zero and leave you without a roof over your head.
What Are Alternatives to a Home Equity Loan?
The best alternatives to a home equity loan depend on the amount needed, the purpose, and how quickly you need the cash. Budgeting and saving for a known expense is your best option. If you don’t have that ability, an auto loan, 0% APR credit card, personal loan, or student loan are all options that still carry risks but don’t use your home as collateral.
What Is the Best Use of a Home Equity Loan?
“For persons planning a major remodel or renovation, and for certain people who are retired or near retirement, accessing a larger amount of home equity via a true home equity loan can be a good strategy,” Foss says, but adds a note of caution. "You have to look carefully at all your other available resources, your income, the interest rate environment, and other factors before you commit to a home equity loan.”
Is It Easier to Be Approved for a Home Equity Loan or a HELOC?
Both a HELOC and a home equity loan have the same equity requirements, credit score, and debt-to-income requirements. There is no evidence suggesting which type has easier approval requirements.
The Bottom Line
A home equity loan allows you to borrow a lump sum of money against your home’s value to use on whatever you want. Don’t risk your home and waste the hard-earned equity you’ve built in it for anything other than something that will increase your home’s value.