As mortgages get paid down, the equity in a home increases and 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 income or savings, it becomes bad debt. Possible exception: a true financial emergency, if you are confident you'll be able to make the payments.
Below are five situations that represent reasons not to use your HELOC as a source for funds.
- A 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.
1. Pay for a Vacation
HELOCs are a source of cheaper debt than credit cards for consumers to fund their needs and wants. They tend to offer interest rates below 6%, as of June 2020, while credit card rates are stubbornly high, ranging from 12% 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. Although it's cheaper than paying with a credit card, 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 while your home is at risk with a HELOC.
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.
2. Buy a Car
There was a time when HELOC rates were a lot 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 5.61% at the end of the first quarter of 2020, according to Experian. Still, if you have a HELOC, you could decide to tap it to buy your next vehicle.
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 principal, opening up the possibility of making payments on your car longer than the useful life of the car.
3. Pay Off Credit Card Debt
It seems to make sense to pay off expensive debt with cheaper debt. 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.
Before considering a HELOC loan to consolidate credit card debt, examine what were 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.
Due to coronavirus pandemic some banks, including Wells Fargo and Chase Bank, have stopped accepting applications for HELOCs.
4. Pay for College
Because of the often lower interest rate on a HELOC, 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, 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 you might be unable to repay a HELOC fully, 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.
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 while 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.
Total HELOC balances in the U.S. at the end of the first quarter of 2020, a $4 billion decline from the previous quarter, according to the Federal Reserve Bank of New York.
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.