Best and Worst Ways to Use Money from a Home Equity Loan
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Own a home? You can borrow against its equity to pay off high-interest-rate credit debt, fund major home improvements or pay for that Norwegian cruise you’ve always wanted to take. You could even use the money to fund a wedding that costs tens of thousands of dollars.
But not all of these are smart ways to use the dollars from a home equity loan. If you don’t make your payments on such a loan on time, you could lose your home through the foreclosure process. You don’t want to put your single-family home, condo or townhome at risk for frivolous purchases.
What are the best ways to use the money from a home equity loan? What should you avoid? Here are our recommendations.
In this article
What is a home equity loan?
A home equity loan is a type of mortgage based on the equity you’ve built in your home. And what is equity? It’s the difference between what you owe on your mortgage and what your home is worth.
Say your home is worth $300,000. If you owe $200,000 on your mortgage, you have $100,000 of equity. You can then borrow a portion of that equity as a second mortgage called a home equity loan. Lenders vary, but if you have $100,000 of equity, a lender might allow you to borrow up to $80,000 in the form of a home equity loan.
You’ll receive the funds from such a loan in a single payment that you can spend however you like. You’ll pay this back monthly with interest until your loan is paid off. Typically, you can take out a home equity loan for five to 30 years.
There is a risk with home equity loans. In such loans, your home acts as collateral. If you don’t pay on time, your lender can start foreclosure proceedings against you. If you don’t pay up, your lender could own your home. This is why it’s important to make sure you can afford your additional mortgage payment before taking out a home equity loan.
It’s also why it’s important to use your home equity loan dollars wisely.
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The best ways to spend the money from a home equity loan
What are the smartest ways to use the dollars from a home equity loan? Here are our suggestions:
Pay for major home improvements
The best use of a home equity loan is to use it to fund significant home improvements. You can use your loan proceeds for a kitchen remodel, bathroom renovation, second-floor addition, or new master bedroom.
These improvements will boost the enjoyment you get from your home. But they can also increase the value of your property. That will pay off when it’s time to sell.
If you use a home equity loan to pay for improvements that increase the value of your home, you can also write off the interest that you pay on your loan each year on your income taxes. This tax advantage is a plus of a home equity loan that is only available when you use your loan payment in this way.
Pay down credit card debt
The average interest rate on credit cards stood at 20.09% as of February, according to the Federal Reserve Board. That’s high. And if you carry a balance on your cards, these high interest rates mean your credit card debt will grow monthly. Depending on how much credit card debt you have – and credit bureau TransUnion reported that consumers with credit card debt carried an average balance of $5,805 on their cards as of the end of 2022 -- making the minimum required payment each month might not be enough to keep this debt from growing.
That’s why it can be smart to use the funds from a home equity loan to pay off your high-interest-rate credit card debt. That’s because home equity loans come with lower interest rates.
The rate you get on your home equity loan will depend on your credit score and the monthly debts you pay each month, but if your score is solid, you can typically qualify for one with an interest rate near 8%. That’s far lower than the interest rates of credit card debt.
By using the money from a home equity loan to pay off your credit card debt, you are swapping debt with an interest rate at or above 20% with a rate closer to 8%. That can save you thousands of dollars in interest as you pay off what you owe.
The key? Don’t run up new credit card debt while paying off your home equity loan. Doing that will defeat the purpose of taking out the loan. And make your home equity loan payments on time. You don’t want to run the risk of losing your home.
Investing in real estate
Do you dream of owning a multifamily building that you can use as an investment, charging rent while waiting for the property to increase in value before you sell for a profit? You’re not alone. Many investors turn to real estate to grow their wealth.
The challenge is that buying investment real estate is expensive. Even if you finance this purchase with a mortgage, you’ll often need tens of thousands of dollars for a down payment.
You can use the funds from a home equity loan to calculate this down payment. Depending on the cost of the investment property you want to buy and the amount of equity you’ve built in your home, you might be able to fund the entire purchase with a home equity loan.
Just be aware: There is never a guarantee that the investment property you buy will increase in value. No investment is guaranteed to bring back a strong return. And if yours doesn’t? You’re still on the hook for paying back the money you borrowed.
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The worst ways to use a home equity loan
As with all financial tools, there are plenty of ways to misuse a home equity loan. Here are some of the worst ways to spend the money from these loans.
Paying for your children’s college tuition
You might be tempted to take out a home equity loan to cover the cost of your children’s tuition. But resist this temptation. Don’t put your home at risk for a degree that your children might not even complete or use after graduation.
A college education is important. But your children have other options to fund it: They can take out private or public student loans. You can take out Parent PLUS loans to help finance the cost. Your children can take other steps to reduce the cost of college, such as attending community college for two years before transferring to a more expensive university.
Paying for a wedding
We get it: Weddings are expensive today. Wedding planning site Zola says that the average cost of a wedding in 2023 stands at $29,000. But don’t take out a home equity loan to cover the costs of your big day. If you do, you risk your home for a one-night event.
Instead, find ways to reduce the costs of your wedding. Just because the average wedding cost is $29,000 doesn’t mean you have to spend that much. Cut down on the number of guests. Hold your event at a less expensive venue. Choose less expensive meal and drink options.
Paying for a big vacation
The general rule? Never take out a home equity loan to pay for frivolous expenses. A big vacation, while certainly enjoyable, is not a necessity. If you can’t afford to pay for that vacation with your savings, don’t put your home at risk to come up with the funds.
The better choice? Save your dollars until you can pay for that vacation in cash.
Buying a new car
You might need a new car. But don’t tap your home’s equity to pay for one. Again, this comes down to collateral: If you take out a home equity loan to cover the cost of a new car, you risk your home. If you miss your home equity loan payments, your lender can foreclose on you and take ownership of your home.
That risk is not worth the pleasures of a new ride. Instead, purchase a cheaper new car or used car. Take out an auto loan with a reasonable monthly payment to finance it.
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The bottom line
A home equity loan can be a useful tool to fund the cost of home renovations or to pay off your credit card debt. But because a home equity loan is a collateral loan in which your home could be at risk if you can’t make your payments, avoid taking out one to fund unnecessary purchases such as vacations, cruises, or weddings.
And before you take out a home equity loan for any purchase? Make sure that your budget can comfortably afford the new monthly payment of these loans.
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Writer
Dan Rafter is a freelance writer who has more than 20 years experience covering personal finance. He's written for the Chicago Tribune, Washington Post, Bankrate, CreditCards.com, Rocket Mortgage, NortonLifeLock and several others.
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