For decades, homeowners across the country have reaped the benefits of a variety of home equity loans. In general, interest rates on these loans are lower than those attached to most credit cards and unsecured personal loans. At tax time, home equity borrowers often enjoy a substantial break by deducting the interest paid on their loans, up to $100,000.



Home Equity Loan Basics

There are two types of home equity loans. The most conventional (sometimes called a “second mortgage”) is paid in a lump sum, with a fixed interest rate and set monthly payments. The home equity line of credit or HELOC is an account from which the borrower can make withdrawals as frequently as they like, provided they don't exceed their credit limit. HELOC interest rates are usually variable, meaning your monthly payments will adjust, depending on federal rates. Loan payments are based on the amount withdrawn, not the total amount you can borrow.

Choosing Wisely

Lump-sum home equity loans are usually a good choice if you have a specific project or purchase in mind, such as renovating your bath or replacing that old clunker of a vehicle. Since HELOCs work more like credit cards, they are well-suited to an ongoing expense like college tuition and provide the convenience of multiple withdrawals. In each case, the most important consideration when borrowing against your home's equity is that you use the money wisely. Be sure you're improving your immediate financial situation without jeopardizing the future. After all, your home is probably your biggest investment, and any loan could, potentially, lead to the loss of that investment.

Five Smart Ways to Use a Home Equity Line of Credit

1. Consolidate Debt

You don't need perfect credit to qualify for a home equity loan, and borrowers often use their loans to pay off high-interest debt and, potentially, improve their credit rating.

2. Build Your Dreams

Whether updating your kitchen or enhancing the home's exterior, these projects can increase the value of your home at resale time. The interest you pay could also provide a tax deduction. There are also government-backed financial incentives for homeowners who install environmentally-friendly features like insulated windows and energy-efficient heating systems.

3. Finance an Education

With college tuition costs escalating, using a home equity loan to pay for your student's education could be the smartest move you make.

4. Grow Your Business

Access to cash is a crucial step in starting your own business. Used wisely, a home equity loan can be a convenient source of seed money.

5. Be Prepared

Your home equity loan can also provide a hedge against employment uncertainty or catastrophic events. Many HELOC borrowers treat their loans as “security blankets” to keep on hand for emergencies.

A Few Not-so-Smart Ways to Use a Home Equity Line of Credit

Ransoming your future

A second mortgage is just that – an additional loan with monthly payments. Borrowing more than you can afford to pay is worse than foolish; it's potentially ruinous to your finances.

Paying for frivolous expenses

Designer shoe sale? Plasma screen TV as impulse buy? Probably not the best uses for your HELOC.

Falling back into the debt trap

One of the risks of using a home equity loan to consolidate debt is that – unless your spending habits change radically – you could wind up in even worse debt than before and lose your home. As a one-time strategy for taking control and paying off credit cards, a home equity loan is beneficial only if your household spending habits undergo a radical transformation.