As a mortgage is paid down, the equity in the home increases. Home equity credit lines of credit (HELOCs) allow homeowners to borrow from a portion of that equity. Home equity can be a valuable resource for homeowners, but it is also a precious one that is easily squandered if used capriciously.
A HELOC can be a worthwhile investment when you use it to improve the value of your home. However, when you use it to pay for things that are otherwise not affordable with your current income and savings, it can become another type of bad debt. One possible exception to this “rule” is in the event of a true financial emergency (as long as you are confident that you’ll be able to make the payments).
“We don’t like seeing people break into the piggy bank and take out equity for other uses,” says Melinda Opperman, president of the nonprofit Credit.org. “Homeowners should only do it if they are using the funds to improve their property.”
Below are five situations for which using a HELOC as a source of funds may be inadvisable.
- A home equity line of credit (HELOC) can be a good idea when you use it to fund improvements that increase the value of your home.
- In a true financial emergency, a HELOC can be a source of lower-interest cash compared to other sources, such as credit cards and personal loans.
- It’s not a good idea to use a HELOC to fund a vacation, buy a car, pay off credit card debt, pay for college, or invest in real estate.
- If you fail to make payments on a HELOC, you could lose your house to foreclosure.
1. Pay for a Vacation
Compared to credit cards, HELOCs are a cheaper source of debt by which consumers can fund their expenses. They tend to offer interest rates below 6%, while credit card rates are stubbornly high, ranging from 14% to 25%.
Regardless, using a home equity line to pay for a vacation or to fund leisure and entertainment activities is an indicator that you’re spending beyond your means. It’s cheaper than paying with a credit card, but it’s still debt. If you use debt to fund your lifestyle, borrowing from home equity will only exacerbate the problem. At least with credit cards, you are only risking your credit—with a HELOC, your home is at risk.
2. Buy a Car
There was a time when HELOC rates were much lower than the rates offered on auto loans, which made it tempting to use the cheaper money to buy a car. That’s no longer the case: The average rate for a loan for a new car was 4.67% at the end of the fourth quarter of 2021, according to the Federal Reserve. Still, if you have a HELOC, you could tap it to buy your next vehicle.
Since the passage of the Tax Cuts and Jobs Act in 2017, taxpayers are only able to deduct the interest on a HELOC if they use the money to build or perform home improvements. All other uses are no longer deductible.
But buying a car with a HELOC loan is a bad idea for several reasons. First, an auto loan is secured by your car. If your financial situation worsens, you stand to lose only the car. If you are unable to make payments on a HELOC, you may lose your house. And second, an automobile is a depreciating asset.
With an auto loan, you pay down a portion of your principal with each payment, ensuring that, at a predetermined point in time, you completely pay off your loan. However, with most HELOC loans, you are not required to pay down the principal, opening up the possibility of making payments on your car longer than the useful life of the car.
At the start of the coronavirus pandemic, some banks, including Wells Fargo and Chase, stopped accepting applications for HELOCs and have not yet changed the policy. Citi stopped offering HELOCs in March 2021.
3. Pay Off Debt
Paying off expensive debt with cheaper debt seems to make sense. After all, debt is debt. However, in some cases, this debt transfer may not address the underlying problem, which could be a lack of income or an inability to control spending.
Consolidating high interest debt from credit cards into a HELOC or home equity loan can be a great money-saving technique, but it’s only helpful if the underlying cause of the original debt is addressed.
—Daniel Yerger, Certified Financial Planner, MY Wealth Planners
Before considering a HELOC loan to consolidate credit card debt, for instance, examine the drivers that created the credit card debt in the first place. Otherwise, you may be trading one problem for an even bigger problem. Using a HELOC to pay off credit card debt can only work if you have the strict discipline to pay down the principal on the loan within a couple of years.
Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps that you can take. One such step is to file a report with the Consumer Financial Protection Bureau (CFPB) or the U.S. Department of Housing and Urban Development (HUD).
4. Pay for College
Because HELOCs often offer lower interest rates, you may rationalize tapping your home equity to pay for a child’s college education. However, doing this may put your house at risk should your financial situation change for the worse. If the loan is significant and you’re unable to pay down the principal within five to 10 years, then you also risk carrying the additional mortgage debt into retirement.
Student loans are structured as installment loans, requiring principal and interest payments and coming with a definitive term.
If you believe that you might be unable to repay a HELOC fully, then a student loan is usually a better option. And remember, if it’s your child who takes out the student loan, they have many more income-earning years before retirement to repay it than you do.
Total HELOC balances in the United States at the end of the fourth quarter of 2021—a $1 billion increase from the previous quarter, according to the Federal Reserve Bank of New York.
5. Invest in Real Estate
When real estate values were surging in the 2000s, it was common for people to borrow from their home equity to invest or speculate in real estate investments. As long as real estate prices were rising quickly, people were able to make money. However, when real estate prices crashed, people became trapped, owning properties whereby some were valued at less than their outstanding mortgages and HELOC loans.
Investing in real estate is still a risky proposition. Many unforeseen problems can arise, such as unexpected expenses in renovating a property or a sudden downturn in the real estate market. And though it’s unclear how the COVID-19 pandemic will affect real estate prices, a rise in value may not be in the near future. Real estate or any type of investment poses too big a risk when you’re funding your investing adventures with the equity in your home. The risks are even greater for inexperienced investors.
Can I Pay Off a Mortgage Using a HELOC?
Paying off a mortgage with a home equity line of credit (HELOC) is technically possible. It is essentially a way of refinancing your loan, but actual refinancing is a much simpler option for reducing an interest rate on a mortgage to pay it off more quickly. The interest-only repayment option is an attractive feature of a HELOC. However, at the end of the draw period, the interest and principal will be rolled into one amortized monthly payment for a loan term of 15 years. If you are not prepared for this, then the increase in your monthly payment could catch you by surprise.
Should I Use a HELOC for a Down Payment?
Using a HELOC on your primary residence as a down payment on a second property is risky. You should understand the risks of real estate investing and make sure that you have the monthly cash flow to pay the mortgages on both properties in addition to your HELOC. If you are able to do that, then a HELOC may be the best way for you to get the cash for a down payment.
If I Need Cash ASAP, What Are Some HELOC Alternatives?
Depending on how much cash you need, a cash-out refinance, a credit card with a 0% annual percentage rate (APR) promotional interest rate (provided that you pay it off before it is due), taking out a car loan through a local credit union on your paid-off car, or taking a loan from your 401(k) are all possible options. Each option has pros and cons and should be considered carefully.
The Bottom Line
Although home improvement remains the top—and the best—reason for tapping home equity, homeowners must not forget the hard lessons of the past by taking out money for just about any reason. During the housing bubble, many homeowners with HELOCs extended to as much as 100% of their home value. As a result, they found themselves trapped in an equity crunch when home values crashed, leaving them upside down in their loans.
The equity in your home that you build up over time is precious and worth protecting. However, emergencies might arise when you need to tap into the equity to see you through, or your home might need renovations. The five examples outlined in this article don’t rise to that level of importance.