In many regions of the United States, home values are continuing to rebound, swelling the home equity available to homeowners. According to a new Transunion study, 1.6 million homeowners are expected to open home equity lines of credit (HELOC) in 2018; the average HELOC established by mid-2017 was $202,121. With HELOC rates averaging 5.8% in April 2018, homeowners are, once again, eagerly turning to their home equity as a source of cheap money to fund their needs and wants.
Although home improvement remains the top – and the best – reason for tapping home equity, many homeowners may be forgetting 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 found themselves trapped in an equity crunch when home values crashed, leaving them upside-down in their loans.
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.
What's more, since the passage of the 2017 tax bill, taxpayers will only be able to deduct the interest on a HELOC if they use the tapped money to do build or do improvements on the home that secures the loan; all other uses are no longer deductible. Following are five situations that represent reasons not to use your HELOC as a source for funds.
1. Paying for a Vacation
Any time you use debt to pay for a vacation or to fund leisure and entertainment activities, it means you are living beyond your means. Although it is cheaper than paying with a credit card, it is still debt. If you generally can’t control your spending – or you rely heavily on 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. There is more at stake with home equity; namely, your home.
2. Buying 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: Current average HELOC interest rates are 5.9%, while a 60-month auto loan is 4.59%. 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. Paying 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 is the inability to live within your means. Before considering a HELOC loan to consolidate credit card debt, honestly examine the reason your credit card debt became so unmanageable 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.
4. Paying 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 are unable to pay down the principal within 5 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 lack the discipline 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, he or she has many more income-earning years before retirement to repay it than you do. Use student loans first.
5. Investing 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, once real estate prices started to fall, people became trapped, owning multiple properties that, in many cases, were valued at less than their outstanding mortgages and HELOC loans.
Although the real estate market has stabilized, 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. Especially if you are an inexperienced investor, 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 Bottom Line
The equity in your home that you build up over time is precious and worth protecting from frivolous use. There may be emergencies when you need to tap that equity to see you through, or worthwhile reasons that build your home's ultimate value, such as certain renovations. The five examples here – paying for a vacation, buying a car, paying off credit card debt, paying for college or investing in real estate – generally don't rise to that level of importance.
Home Equity Lines of Credit (HELOCs) & Home Equity Loans
The Smartest Way to Tap Your Home Equity
Refinancing Your Home Equity Loan: A How-to Guide
How a HELOC Fixed-Rate Option Works
Refinancing vs. Home Equity Loan
Home Equity Loan vs HELOC
Home Equity Line of Credit: 4 Ways to Refinance
Is the Interest on a Home Equity Line of Credit (HELOC) Tax Deductible?
Bad Credit? You Can Still Get a Home Equity Loan
Mortgages vs. Home Equity Loans: How They Differ
What to Do If You Can't Pay Back a Home Equity Loan