We all dream of cheap credit with lower interest rates and longer repayment terms in order to fund such things as home improvements or special vacations. For this reason, many homeowners are tempted to borrow against their home’s equity in order to leverage a purchase for larger-ticket items.

Tuck Associates, a firm that specializes in solutions for consumers and small business owners with debt issues, has a few suggestions to help homeowners decide when it makes sense to pursue home equity loans and when it does not make sense.

Home Equity Loan Versus Home Equity Line of Credit (HELOC)

Home Equity Loan: There is a distinction that borrowers need to understand. A home equity loan is a one-time loan against the equity you have invested in your home. It carries a fixed interest rate. Often, people will use a home equity loan for a major home project, like remodeling or renovation. With the fixed interest rate and the one lump sum, you will eventually pay off the home equity loan at the end of its term.

According to Nerdwallet, one drawback of a home equity loan is the fact that you have another payment to make each month that can cause you to lose your home if you default. Another drawback is that a large draw against your equity can go against you if home prices in your area decline, as they did during the Great Recession.

HELOC: A home equity line of credit is a line of credit, meaning an amount that the bank will allow you to draw against the equity in your home. Nerdwallet likens it to a credit card. You can make small draws or one large draw against your HELOC. It is up to you. This is good in a way because you can contain the amount of money you borrow and thus the interest you will pay. Also, some HELOCs allow you to make interest-only payments during the time period you are allowed to make draws against your equity.

Drawbacks of a HELOC are that the interest rates are not fixed, defaults will allow the bank to take your home and that you might be tempted to either overspend using the HELOC or that you might use it to pay off unsecured debt.

Secured Versus Unsecured Debt

One of the biggest problems that can get homeowners in trouble is if they use home equity loans of any type to pay down unsecured debt. People often try to pay off their unsecured credit card debt at high interest with lower-interest home equity loans. The problem is that, if you get into difficulties financially, such as if you become ill and cannot work or if you become unemployed, home equity loans of any type that are defaulted on will allow the bank to take your home.

Sometimes, if all you are trying to do is get under unsecured credit card debt at higher interest, it is usually better to take out a personal debt consolidation loan. Those loans are also often at a lower interest rate and allow you to make fixed monthly payments with an end payoff date. Debt consolidation loans are unsecured, so your home is not put up as collateral if you default.

A Good Use for Home Equity Loans

According to The Balance, one really great use for a home equity loan is if you plan on making improvements to your home that will add to its equity. As long as the prices of homes in your area do not fall, this would be a far safer use of a home equity loan. Also, the only remaining tax deduction on home equity loans is if you use them to make substantial improvements to your home, so you will also get a tax deduction on interest on the home equity loan.

Tuck Associates suggests that homeowners approach home equity loans with caution and only use them to substantially improve their home. Then, the tax benefits and the increased equity earned with the improvements may offset the cost of the loan. Otherwise, they are usually best avoided, due to the risk of losing your home if you default. Tuck Associates has solutions for homeowners and other consumers who are searching for financing options. Call us with any questions you may have