3 Tips to Use Home Equity Loans the Right Way

If you're strapped for cash, or starting a business, you may look to your home for a loan. Before you decide to tap your home's equity, here are three tips to consider.

1.  The term home equity sounds a bit complex, but it's simply the difference between your home's current market value and what you still owe on it. For example, a home that's worth $250,000 and has a $200,000 mortgage balance has $50,000 in equity.

During the last decade, declines in real estate values in many parts of the country erased equity and made it tough to get home equity loans. Today, as values recover, if you're a homeowner with a solid credit history and home equity, you may be able to use this equity as collateral to borrow money with two key benefits: 

• Low rates. Home equity rates are usually much lower than what you'd pay for a credit card or other loans that don't require collateral. 
• Tax breaks. You can deduct interest on up to $100,000 of home equity debt ($50,000 for married couples filing separate returns.) 

2.  There are two ways to borrow against your equity: 

• Home equity loans immediately advance you a specific amount of money and usually require payments over a fixed period at a fixed interest rate. 
• Home equity lines of credit give you the option of borrowing money as you need it, up to the amount your lender approves for you. Rates are variable, so your payments will fluctuate with changes in interest rates and will vary as your balance changes. 

Whether a loan or line of credit is best for you depends on your needs. If you want the certainty of a fixed interest rate and predictable monthly payments, choose a home equity loan. If you want future flexibility, a home equity line of credit may be the right call. 

3. . Home equity interest rates are attractive to lenders because you pledge your family's shelter as collateral. If you struggle to repay a home equity loan or line of credit, you put your home at risk.

Your first consideration shouldn't be how much you borrow, but rather why you need it. Debt is best used to improve your financial position or to purchase necessities with lasting value. That means you probably shouldn't use a home equity loan for clothing, vacations, gifts, gadgets or impulse purchases no matter how low your after-tax cost of borrowing.

Here are a few potentially wise uses of home equity debt: 

• Debt consolidation. By consolidating multiple balances into a single home equity loan, you can simplify your life and potentially realize a dramatic reduction in your borrowing costs. But beware: Debt consolidation only works if you have discipline. If you run your credit card balances back up again, you'll be in worse shape than before your consolidation. 
• Home improvement. Before you upgrade your kitchen counters or expand your master bathroom, consider the long-term economic value of the project and how long you expect to remain in the home and enjoy the results. Also, keep in mind that if home market values fall, as they did during the last recession, this could potentially erase the value of those improvements. 
• Covering college costs. Home equity can be an efficient way to borrow money for college, but make sure you've explored federally sponsored alternatives. As you do, remember that you may be able to deduct up to $2,500 in student loan interest, depending on your income. And while education is a sound investment in your child's future, make sure debt doesn't hinder your own drive for financial security and retirement. 
• Starting a business. You may want to consider a home equity loan to finance a startup business or a business you are purchasing. Home equity loans usually don’t come with the restrictions associated with many business loans. As a result, you have more freedom in deciding how you spend the money. Before choosing this option to fund a business, consider the following: From a cash flow perspective, will you be able to service the debt - make the loan payments - assuming your business using the home equity funds doesn't work out?  If your business struggles, and you find it difficult to repay a home equity loan or line of credit, you put your home at risk.

Home equity is a good option for many important financial goals, but you have to balance risk against potential reward. It’s recommended you discuss your situation with a trusted financial advisor before tapping into your home equity.

This article is not intended to provide legal, tax or investment advice. Always seek professional advice from trusted advisors as to how a using a home equity loan or line of credit might benefit you.