A home equity loan is a loan you take out from a financial institution that uses your home as collateral. In other words, if you don’t repay the loan, you’re putting your house at risk of being foreclosed on.
While the fact you’re putting your house in jeopardy is a huge downside, home equity loans also have some upsides, including low interest rates and the fact that interest is tax-deductible in some cases. But, you don’t want to take out this type of loan unless you have a good reason to do so.
Here are two of the single best reasons for borrowing against the equity of your home.
1. Home improvement
Fixing up your home is a great use for home equity loans because if you use the loan proceeds for home repairs, interest on it should be tax deductible as long as you itemize. The tax savings makes this type of loan even more affordable.
The improvements you’re doing to your home should also hopefully increase your property’s value. This helps keep your total loan-to-value ratio lower even if you are increasing it by tapping the equity in your house. The loan-to-value ratio measures the amount of your mortgage to the value of your home.
You don’t want to borrow so much that you owe close to the amount your home is worth. Otherwise, refinancing or selling could become difficult since you may not be able to generate enough money from the sale of your home to repay your current loans.
2. Debt consolidation
Debt consolidation can be another good use for a home equity loan because it’s a process that should improve your overall financial situation.
When you consolidate debt using a home equity loan, you use the loan proceeds to pay off other debts, such as high interest credit card debt. By lowering the cost of these other loans, you’d save on interest over time and could perhaps even become debt-free faster.
In many cases, debt consolidation can also lower your total monthly payments. If you consolidate multiple debts into one home equity loan with a lower interest rate than your previous creditors were charging, the total monthly payments you have may drop. If you reduce those payments, you reduce the chances of getting into financial trouble and becoming unable to pay off your home loan. You also free up money for other financial goals.
Of course, when you consolidate debt, you’ll usually end up converting unsecured debt to secured debt. That means you take loans that don’t have collateral guaranteeing them — such as credit card debt — and you convert them into a home equity loan that is secured by your house. You need to be 100% sure that you’ll be able to afford your home equity loan payments on top of your mortgage payments before you take this approach.
There may also be other reasons why you decide to take a home equity loan. But, before you move forward, make sure you’ve carefully thought the risks through and that you’re using the money to do something smart that will improve your overall financial situation.