Thinking of tapping your home equity?

Here are 5 reasons homeowners do so — and why to use caution if you proceed

Borrowing against the equity in your home can be a relatively easy way to access cash quickly. You have several loan options, such as a cash-out refinance, home equity loan or home equity line of credit, but you need to have a good reason for tapping the equity in your home before choosing an option. Here are five common reasons borrowers use equity.

Home improvement is one of the main reasons borrowers will take out a home equity loan or a HELOC. Besides making your home more comfortable to live in, the improvements will increase the value of your house should you sell it.

But if you plan on selling the home, you need to be mindful of the types of improvements you are making to your house. A common homeowner mistake: using equity to make upgrades that don’t actually increase the home’s value.

“If you’re thinking about selling your house soon, you want to be cautious about how much you spend on what, because there’s a limit to how much you can get over the market value on a house,” says Rick Sharga, executive vice president of Ten-X, an online real estate marketplace. “Most real estate folks will say new paint and carpeting, and maybe some upgrades to the kitchen or bathrooms help the value of the house.”

A HELOC or home equity loan can also be a good way to fund a college education because the interest rate might be lower, depending on the type of student loan financing available.

“Paying for education to potentially put yourself in a higher income bracket, that’s a huge positive for using home equity,” says George Pantelaras, director of consumer direct/internet production at Planet Home Lending.

Before tapping the home equity, look at all of your student financing options as well as the terms and interest rates. Because your house is securing the HELOC or home equity loan, you could lose the house if you default, whereas defaulting on a student loan will hurt only your credit.

Homeowners will often use their home equity to pay off other personal debt like a car loan or a credit card. HELOCs or a home equity loan can sometimes be a way of consolidating your debt to a lower interest rate.

But this can become dangerous when the homeowner adds on even more credit card debt after taking out a HELOC to consolidate the old debt.

“If you’re planning on tapping home equity to pay off debt, there’d better be a good management plan in place,” says Pantelaras.

There are also closing costs involved with getting a home equity loan or HELOC, so you need to look at how much it will cost you overall to borrow against your home equity.

“You’re paying a lot of money upfront to pay off the other debt, so it’s got to make financial sense,” says Pantelaras.

Some homeowners use their home equity to invest in the stock market or in real estate properties to get a higher return than what they pay on the interest rate. This has its risks, because there are no guarantees that the stock market will always outperform the cost of the HELOC or home equity loan.

Similarly, if you use home equity to invest in real estate, there’s no guarantee that investment property will sell at a price worthy of the cost it might take to increase the value of that property.

“People tend to sometimes overvalue a property they want to invest in or underestimate the costs involved,” says Sharga. “It’s really abut financial management and whether it makes sense to start with other investors or real estate professionals.”

Most lenders agree that the worst reason to tap your home equity is for unnecessary personal spending like an extravagant vacation, car or boat.

“These were the things people got in trouble with during the housing market boom,” says Sharga. “They used their house as an ATM.”

Simply put, don’t overspend and don’t overborrow when it comes to your home equity.