Avoid the pitfalls of home equity loans

When a large expense is looming on the horizon, it can be tempting to consider drawing on your home's equity. Just like breaking open a piggy bank, your home's value can provide a ready source of funds.

With home values increasing in recent years, many homeowners have indeed taken his step. According to the Wall Street Journal, the number of homeowners drawing on their equity is at its highest point since the Great Recession. Almost half of those who refinanced their property in the first quarter of 2017 did so with a cash-out option, allowing them to pocket a lump sum of money.

Homeowners can also benefit from their home's value by getting a home equity loan or home equity line of credit. The former option lets you borrow against your property's equity, paying the lender back over a set amount of time with a fixed-rate loan. The latter also lets you leverage your home equity, serving as a variable rate loan where you can borrow money as needed up to a certain spending cap.

While some homeowners won't reap the financial benefits of owning a home until they sell it, drawing on the home equity allows you to access that wealth earlier. However, you'll want to make sure you understand all of the costs, risks, and pitfalls associated with the process.

USE OF FUNDS

One of the most important considerations when using your home equity is the question of how you will spend the money. It is best to use these funds for expenses that can improve your home or otherwise serve as an investment, not for one-time costs.

Home equity is frequently invested back into the home to improve it and further boost its value. James E. McWhinney, writing for the financial site Investopedia, says tapping into equity is a good way to pay for costly one-time repairs or renovations, such as putting on a new roof. Many renovations have a high return on investment, improving the value of the home enough to recoup most or all of their cost.

The source of funds can also be particularly useful in some emergencies, such as paying an expensive medical bill. Broderick Perkins, writing for the legal site Nolo, says some financial advisers have suggested that homeowners draw on their home equity early if they anticipate an upcoming need for funds. For example, lenders may be less likely to approve the transaction if the borrower has lost his or her job.

Borrowing money against home equity can make sense if you plan to use it for a capital investment. You might want to start a small business, purchase another property to collect rental income, or cover the cost of a college education (since this can improve the earning potential of the homeowner or their children).

If you plan to use the money this way, make sure the investment is promising and will have a return at least as good as you would see if you improved your equity through regular mortgage payments. Any business investment should be accompanied by a solid business plan, and anyone benefiting from an education investment should be committed to getting their diploma.

Some borrowers use home equity as a way to consolidate their debts. June Fletcher, writing for the National Association of Realtors' home improvement site HouseLogic, says a home equity loan can replace a credit card debt or other loan with a higher interest rate, potentially saving you money in the long run.

Home equity should never be used to finance expenses with no return on investment. These include depreciating assets such as cars, recreational vehicles, or boats; one-time experiences such as vacations; or consumer goods like furniture and clothing.

You'll also want to assess your spending habits before taking out a home equity loan. McWhinney says some borrowers get into a habit of "reloading," or taking out a loan to pay an existing debt to free up more credit, which is then used to continue spending. This leads to a dangerous cycle of escalating debt.

Perkins says you should never use home equity to pay for expenses such as groceries and utilities. If your income is insufficient to cover these basic needs, you should reassess your household spending and possibly seek financial counseling.

REPAYMENT

You shouldn't be tempted to think of home equity as a source of free money, since any funds you take out will need to be repaid. You'll also want to keep these new monthly payments affordable.

Be reasonable about how much you'll be able to borrow. A lender will review your income information to determine how much you can comfortably afford to take out. Fletcher says you should be wary of any predatory lending tactics, such as offers to overstate your income to qualify you for a larger loan.

Ask plenty of questions to find out how the loan will work. Dana Dratch, writing for the financial site Bankrate, says payments or interest rates on some loans will increase over time. Review how the loan may change, determine how much it will cost to tap into the home equity, and see if there are any penalties for paying off the loan early.

Don't take out a loan without a plan for paying it back. You shouldn't rely on money you don't have yet, such as an expectation of a raise or bonus. Don't forget to plan for situations such as how you will pay back the loan if your home sells for less than expected.

Shop around before deciding on a lender. You may be able to find a more advantageous rate or repayment plan.

Ideally, you should be able to pay back a home equity loan faster than scheduled. Kerry Hannon, writing for the financial site Next Avenue, says doing so will let you pay down the principal more quickly and avoid contributing too much in interest.

KNOW THE RISKS

The biggest risk of drawing on your home equity is the increased possibility of losing your home. Dratch says that by paying off some debts, such as those related to credit cards or student loans, you'll replace an unsecured debt with a secured debt. In other words, you'll still have the same amount of debt but your home will now serve as collateral and a lender could seize it due to non-payment.

Even though home equity loans are usually much smaller than the home's value, they can still trigger foreclosure proceedings if not paid. Fletcher says the holder of a second lien may not sign off on a short sale on the primary mortgage if the home sells for less than that mortgage balance.

Tapping into your home equity will collect some of the profit you wouldn't have seen until the sale of the home. Naturally, this means you may not be able to collect as much when you sell, since you'll need to pay off both the mortgage and the home equity loan. It may not be worthwhile to draw on the home equity if you're planning to sell in the near future.

Consult with a financial adviser or other expert before deciding whether to use your home equity as a source of cash. This process can often be beneficial, but not in all circumstances.