The equity you have in your home amounts to the difference between the value of your home and the amount of money you still owe on your mortgage — in other words, it’s the amount of your home’s value that you own outright. Equity can be used as collateral for a home equity loan or a home equity line of credit.
Home equity loans and HELOCs are second mortgages that are separate from your current loan. A home equity loan is a lump-sum loan with a fixed interest rate, whereas HELOC rates are generally variable. Additionally, a HELOC is more like a credit card: You can draw from the equity line of credit over time when you need to, and you only pay interest on the amount you’ve borrowed.
Here’s what you need to know about taking out a home equity loan or line of credit.
5 Best Ways to Use Home Equity
Equity is one of the biggest benefits of homeownership. You build equity when your home appreciates naturally over time, you pay down your mortgage principal or make home improvements that increase your home’s value. You can tap into equity at lower rates than you’d pay on other types of loans, and the interest you pay might be tax deductible. Here are the five best ways you can use home equity:
1. Make Home Improvements
Making home improvements is one of the best ways to use equity because those improvements can build more equity by increasing your home’s value. Some improvements, like adding insulation to your attic, can even generate more value than they cost to complete. Other smart projects include those that improve your home’s curb appeal or updates to kitchens and baths.
Check Out: Best Home Improvement Loans
2. Consolidate Debt
Home equity can help you take control of personal debt. For example, there are several advantages to using a home equity loan to pay off multiple high-interest credit card debts. You’ll face only one fixed monthly payment, and since home equity loans generally carry lower interest rates than revolving credit card debt, that payment is likely to be much more attractive.
3. Pay for College
Harnessing the equity in your home can be a smart way to pay for college if you consider variables like the length of the loan and the interest rate. Because many parents face their own retirement within five or 10 years of financing a child’s education, this is a personal decision. You might consider a blended approach, leveraging equity and utilizing education-specific loans or government programs.
4. Build an Emergency Fund
An emergency fund is a critical piece of the financial security puzzle. You should have several months’ worth of readily available money saved in an interest-bearing account. For many, that’s simply not realistic. In some cases, a HELOC is a smart way to gain quick access to money if you have an emergency, and you can pay it back over time.
5. Invest in Real Estate
You might consider using the equity in your home as a down payment to purchase, rehabilitate or renovate an investment property you can rent for supplemental income. Investment properties can provide financial security and independence, but only if they earn enough rent to cover the loan. You’re still on the hook for the home equity loan, and you might risk losing your primary residence if the investment fails.
5 Worst Ways to Use Home Equity
Although equity can be a powerful tool, it isn’t the best answer for risky or frivolous purchases or those that don’t have long-term value. Both equity options carry interest, and if you default on the loan, you could lose your home. Here are five ways you shouldn’t use home equity:
1. Buy a New Car
Homes are appreciating assets, meaning their value generally increases over time. You shouldn’t use home equity to pay for depreciating assets like cars, which begin losing value the moment you buy them. And if you default on an equity-financed auto loan, you could lose your home as well as your car.
2. Take a Vacation
It’s always nice to go on vacation and get away from home — but not at the expense of your home. No matter how badly you need a vacation, a vacation is a short-term want — one you shouldn’t finance with money that could cost you your home. Instead, use a traditional line of credit or take a cheaper vacation.
3. Invest in the Stock Market
Some investors might be tempted to borrow against their homes because home equity loan rates are typically lower than the average market returns. But those averages are measured over decades. In the short term, market downturns are always a possibility, and when investors use equity to play the market, they risk losing out on both the investment and their homes.
4. Buy Luxuries
Living within your means involves going without certain luxury items. When you want something you don’t need and can’t currently afford, save money, look for bargains or wait for sales deals — but never risk losing your home by borrowing against your equity for things you can live without.
5. Take Out a Loan Before You Sell
The outstanding balance on all debts against your home must be settled before you sell it. Avoid borrowing against your home if you plan to put your home on the market. And don’t take out a home equity loan to make home improvements before you sell, either.
Learn About: 7 Best Types of Loans for People With Bad Credit
Bottom Line About Home Equity and HELOCs
Every time you pay down your mortgage or increase the value of your home, you build equity. Equity is one of the biggest benefits of owning a home and a reliable key to a homeowner’s financial security. Equity can be a powerful tool — if you use it wisely and for the right reasons.
Whether you choose a home equity loan or a HELOC, if the market value of the home falls below the amount of the loan, you’ll find yourself in a negative-equity situation. Most lenders don’t allow homeowners to borrow 100 percent of the equity in their real property home values; the typical amount is limited to around 85 percent. Before making a decision, understand your home equity loan requirements and loan rates — and be sure to shop around for the best deal.
Daria Uhlig contributed to the reporting for this article.
This article originally appeared on GOBankingRates.com: 5 Best and Worst Ways to Leverage Your Home Equity