A home equity loan is one which lets you borrow money using the equity in your property as collateral. Equity is the amount of money you've already paid on your mortgage. With a home equity loan, you can borrow against the equity, and what you do with the cash you receive is up to you. However, there are good reasons and bad reasons for getting a home equity loan. Before you start shopping for one, make sure you that you have a definite goal for the money – one that is part of a financial strategy that will increase your overall wealth.
The Good Reasons
Taking out a home equity loan for the purpose of putting the money back in the property is perhaps the single best reason for getting this type of loan. If you make improvements wisely, you can increase your property's value far beyond the cost of the loan. A kitchen or bathroom remodel or the addition of an extra bathroom generally offers the best return on your investment. If you decide to finance home improvements in this way, bear in mind that you should not increase your home's value more than 15% over the average value of those in your neighborhood. Going beyond this figure means that you potentially limit the resale value of your home, because your property's value is dragged down by the average value of those surrounding you.
Using the cash from a home equity loan to finance higher-yield investments is another good option. You might, for example, consider using a home equity loan to finance the purchase of an investment property, retirement, or vacation home. If you decide to purchase a second home or investment property, make sure you do some research and find out about applicable tax laws. For example, estate taxes on a vacation property are tax-deductible as long as you live there for more than two weeks per year, and don't rent it out for more than two weeks per year.
The Bad Reasons
Debt consolidation sounds like a great way of solving credit card problems, and it is in fact how most people use home equity loans. It's an attractive prospect, because you can use a home equity loan to pay off multiple smaller debts, leaving you with one monthly payment that has a lower interest rate than your credit card debts. However, by using a home equity loan for this purpose, you're also turning unsecured debts into a debt that's secured against your house. Just as important, you're not really addressing the problem that put you in this position in the first place. Rather than get a new loan to pay off old debts, it's better to fix the problems that led to accumulating that much unsecured debt.
Don't use a home equity loan to finance cars, boats, recreational vehicles, expensive electronics or vacations. It's an attractive idea to use one to finance a dream vacation or an expensive new car – but you're putting your property on the line for something that will lose its value long before your home does.