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Home equity loans can be a great way to get much-needed cash at a reasonable interest rate, but they can also get you into trouble if used the wrong way. In fact, misuse of home equity lending was one of the main contributors to the Great Recession. Here are four perfectly good reasons to tap into the equity in your home, as well as a few generally bad ones.
1. Home improvements that will add value
One common and practical use of home equity is to make home improvements. However, make sure whatever improvements you make add value to your home.
For example, a moderate kitchen remodel adds 72% of its cost to your home's value. Upgrading exterior siding can add 78% of the cost. Certain energy-efficient upgrades could give you tax benefits and lower energy bills in addition to adding value to the home.
However, additions like pools and other luxuries are not likely to add too much to your home's value. A $70,000 kitchen in a $200,000 house simply doesn't make sense and is not something buyers are willing to pay much of a premium for.
2. Emergency expenses
It's always a good idea to have an "emergency fund" available, but using home equity to cover unexpected costs is an acceptable reason for borrowing. Large medical expenses, a job loss, or any other costly, unexpected situation could be a good reason for tapping into your equity.
3. Consolidating high-interest debt
This could save you a lot of money over the long run. Let's say you have $20,000 in credit card debt, and your average interest rate is 17%. By using a home equity loan to pay your debt off, you could save yourself about $2,000 in interest, which you could then use to pay down the principal faster.
Even though home equity loans typically carry higher interest rates than first mortgage loans -- about 7.4% for a fixed-rate 25-year term, as of this writing -- they're still preferable to paying a double-digit rate for the next decade or more.
4. Funding investment properties (carefully)
So long as the rent you collect covers your home equity loan's payment and the amount of your mortgage plus your home equity loan is less than 80% of your home's value, this can be a good use of your equity.
Where people get into trouble is using equity to fund vacation homes for themselves or borrowing 100% of their home's value to invest. Although 100% home equity loans aren't too common anymore, 90% or so is not too hard to find, especially if you have good credit.
Bad reasons to use your home's equity
There are plenty of things you should never finance with your home's equity -- even though people do it all the time.
One thing that was much more common in the pre-recession years was the financing of luxury items. People would use the equity in their home -- and I mean all of it, not just the 80% maximum that is now standard -- to buy luxury cars, vacations, or expensive clothing.
Also, basic expenses like groceries, clothing, utilities, and phone bills should be a part of your household budget. If your budget doesn't cover these and you're thinking of borrowing money to afford them, it's time to rework your budget and trim some of the excess.
In a nutshell, don't use your home equity for anything that won't produce a positive return. Paying off high-interest credit cards will save you tons of money in the long run. Improving your home builds back some of the equity you're borrowing.
Basically, you should look at home equity loans as investments and not as extra cash when making spending decisions. If your intended use of the money doesn't pay you back in some way, it's probably not the best use of your available equity.