Should you use a home equity loan?

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Home equity loans offer many perks, and several pitfalls.

If you own a home and have a steady source of income, you likely can qualify for a home equity loan, also known as a second mortgage. Here we’ll take a look at the different types of home equity loans, and when you should—or shouldn’t—make use of one.

Types of home equity loans

A home equity loan lets you leverage the equity in your home, which is the difference between what you owe and your home’s value. There are two types:

  1. Fixed-rate Loan. You receive a single, lump-sum payment, which you must repay with interest by a certain date.
  2. Home Equity Line of Credit (HELOC). You are pre-approved and can withdraw money as needed up to a certain amount.  You must repay the loan with interest by a specified date.

When it makes sense to use a home equity loan

Home equity loans typically come with attractive interest rates, and all the interest paid is tax deductible (up to $100,000 borrowed). Here’s when you might considering taking out a home equity loan:

  1. Home improvements. Done within reason (a pool is not an improvement is the eyes of all), using a home equity loan to remodel a kitchen or replace a roof can add value to your home.
  2. Education or training. You’re investing in yourself and your future earning potential. However, look closely at your retirement and financial goals if you’re considering a home equity loan to pay for your children’s education.Real estate. When home prices are low, a home equity loan might be used to purchase a rental property or second home. Only do this if your rental income covers your costs or you have some other means of carrying the loan costs. Remember, real estate should be a long-term investment.
  3. Eliminate high-interest credit cards. This only makes sense if you can stop using your credit cards, or are able to pay off your monthly balances with your income.

When not to use a home equity loan

A loan by any other name is still a loan. You’ll pay interest and fees and, in this case, your home is your collateral. If you can’t make your monthly home equity loan payments, you could lose your home…even if you continue paying your mortgage.

Here’s when you should not use a home equity loan or line of credit:

  1. Car purchase. While auto loans may have higher interest rates, you’ll only lose your car if you miss payments…not your house.
  2. Vacations. We all need to get away, but you don’t want to come back to mounting debt.
  3. Groceries, clothing or other consumables.

Generally, you don’t want to use a home equity loan to purchase items with depreciating value. If you need to take out a loan for everyday expenses, seek financial counseling for debt relief.

And if you are considering a home equity loan or line of credit, be sure to shop around to get the best deal and to understand the terms and conditions of the loan. The Federal Trade Commission has a good primer here.

This article contains general information. Individual financial situations are unique; please, consult your financial advisor or tax attorney before utilizing any of the information contained in this article.

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Source: Nolo.com, HouseLogic.com, Federal Trade Commission
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