5 reasons not to use your home equity line of credit (HELOC)
As mortgages are paid off, home equity increases; Home equity lines of credit (HELOC) allow homeowners to borrow against a portion of that equity. Home equity can be a valuable resource for homeowners, but it is also a valuable resource that is easily wasted 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 a different kind of bad debt. A possible exception to this “rule” is in a true financial emergency (as long as you are sure you can make the payments).
Below are five situations in which using a HELOC as a source of funds may not be desirable.
Key points to remember
- A Home Equity Line of Credit (HELOC) can be a good idea when you use it to finance improvements that increase the value of your home.
- In a true financial emergency, a home equity line of credit (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 Home Equity Line of Credit (HELOC) to finance vacations, buy a car, pay off credit card debt, pay for college, or invest in real estate.
- If you can’t make payments on a Home Equity Line of Credit (HELOC), you could lose your home to foreclosure.
1. Pay vacation
HELOCs are a cheaper source of debt for consumers than credit cards to finance their spending. They tend to offer interest rates below 6%, while credit card rate are stubbornly high, ranging from 14% to 25%.
Either way, using a home equity line to pay for vacations or to fund leisure and entertainment activities is an indicator that you are spending beyond your means. While it’s cheaper than paying with a credit card, it’s still debt. If you are using debt to finance your lifestyle, borrowing against home equity will only exacerbate the problem. At least with credit cards, you only risk your credit when your home is in jeopardy with a HELOC.
Since the passage of the Tax Cuts and Jobs Act in 2017, taxpayers can only deduct interest on a HELOC if they use the money to build or make home improvements. All other uses are no longer deductible.
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 on a loan for a new car was 5.61% at the end of the first quarter of 2020, according to Experian. However, if you own a HELOC, you may decide to use it to purchase your next vehicle.
But buying a car with a HELOC loan is a bad idea for several reasons. First of all, a the car loan is guaranteed by your car. If your financial situation deteriorates, you may only lose the car. If you fail to make payments on a HELOC, you risk losing your home. And second, an automobile is a depreciating asset.
With a car loan, you repay part of your main with each payment, ensuring that at a predetermined time you fully repay your loan. However, with most HELOC loans, you are not required to repay the principal, which opens 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 logical to pay off expensive debt with cheaper debt. After all, debt is debt. However, in some cases, this debt transfer may not resolve 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, consider which created credit card debt in the first place. Otherwise, you could trade in a 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 off the loan principal within a few years.
Due to the global pandemic caused by COVID-19, some banks, including Wells Fargo and Chase Bank, have stopped accepting HELOC requests.
4. Pay for college
Because of the often lower interest rate on a HELOC, you can streamline the use of the equity in your home to pay for a child’s college education. However, it can put your home at risk if your financial situation worsens. If the loan is large and you cannot repay the principal within five to ten years, you also risk carrying additional mortgage debt in retirement.
Student loans are structured as installment loans, requiring payments of principal and interest and with a definitive term.
If you think you might be unable to fully repay a HELOC, a student loan is usually a better option. And remember, if your child takes out the student loan, they still have many more years to earn pre-retirement income to pay it off. than you.
5. Invest in real estate
When real estate values were outbreak in the 2000sIt was common for people to borrow against their home equity to invest or speculate in real estate investments. As long as real estate prices were rising rapidly, people could make money. However, when house prices plummeted, people became trapped, owning properties some of which were appraised with less than their mortgages and HELOCs outstanding.
Investing in real estate remains a risky proposition. Many unforeseen issues can arise, such as unexpected expenses related to renovating a property or a sudden downturn in the real estate market. And although it is not clear how the COVID-19 pandemic will affect real estate prices, an increase in value may not be in the near future. Real estate or any type of investment poses too much risk when you finance your investment adventures with the equity in your home. The risks are even greater for inexperienced investors.
$ 362 billion
Total HELOC balances in the United States at the end of the third quarter of 2020 – a decrease of $ 13 billion from the previous quarter, according to the Federal Reserve Bank of New York.
The bottom line
While home improvement remains the number one – and the best – reason to tap home equity, homeowners shouldn’t forget the hard lessons of the past by withdrawing money for any reason. During the real estate bubble, many homeowners owning HELOCs have achieved as much as 100% of their home’s value. As a result, they found themselves trapped in a capital squeeze when home values plummeted, leaving them Upside down in their loans.
The equity in your home that you build up over time is valuable and worth protecting. However, emergencies can arise when you need to tap into equity to help you out, or your home may need renovations. The five examples described in this article do not reach this level of importance.