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Is a home equity loan a good idea?

Think Tank
Mark Johnson,
 Ph.D.
Associate Professor of Finance at Loyola University Maryland Sellinger School of Business and Management
Arindam Bandopadhyaya,
 Ph.D.
Chair of Department of Accounting and Finance at College of Management at University of Massachusetts Boston

With home-price growth building equity for millions of homes across the country, homeowners are once again considering their options when it comes to borrowing against their properties. While home equity borrowing is certainly surging, it does remain well below levels seen prior to the downturn.

So how should homeowners utilize their home equity? What should home equity be spent on, and conversely, what should homeowners avoid wasting their equity on?

To find out, we spoke with Dr. Mark Johnson of Loyola University and Dr. Arindam Bandopadhyaya of the University of Massachusetts Boston to learn about the potential pitfalls or traps that a homeowner should avoid when taking out home equity loans.

Q: Are there "good" and "bad" uses of home equity? Are there pitfalls or traps that a homeowner should avoid? Should homeowners pay for college with home equity loans?
Mark Johnson, Ph.D.
Assistant Professor of Finance at Loyola University Maryland Sellinger School of Business and Management

A:The good: Home-improvement projects

A home equity line of credit (HELOC) is not necessarily a bad source of funding. Of course it is a loan which must be repaid. I think that potential good uses of a HELOC would be a long-term purchase such as a well thought through home improvement (pools typically do not count). And even though, similar to a credit card, a HELOC is a line of credit, but typically does not have a grace period like credit cards.

For example, a credit card company must give you at least 21 days from the time that you receive your bill to pay off the new balance before incurring finance charges. HELOCs can start accruing interest immediately upon drawing funds from the HELOC account. As a result, you typically do not want to use HELOCs for short-term purposes.

The bad: Funding college

I would be reluctant to use a HELOC to pay for a child’s college education. Chances are that if you were approved for a sizable line of credit tied to your home, you would also qualify for a parent loan to help pay for college. Even though the interest rates on HELOCs are typically lower because it is a loan that has collateral (i.e., your home) and the interest can be tax deductible, they are risky loans.

This debt is tied to your home and can have a variable rate, resulting in higher monthly payments if interest rates rise. And at some point in the near future, interest rates should rise. So even though it is tempting to borrow tens of thousands of dollars of your home’s equity, please think carefully about your situation. What is the money for? Are other financing options available? Why not downsize into a smaller home, realize possible capital gains from your primary residence, and possibly use some of these proceeds to assist your child with college? Why not ask your child if they can consider a less expensive college? There are options.

Arindam Bandopadhyaya, Ph.D.
Chair of Department of Accounting and Finance, College of Management at University of Massachusetts Boston

A: Good uses of home equity loans include home repairs, debt consolidation, funding education, and large ticket items that a family absolutely needs like a refrigerator or washing machine.

Bad uses include vacations and “toys” (i.e. golf clubs and automobiles that go above and beyond what you need and can afford).

Home equity loans: Not a substitute for saving

In my opinion, home equity loans should not be a substitute for savings. When consolidating debt, remember that you are not “paying” debt off – you are just putting everything into one place. Watch out for the terms of the loan. Beware of teaser rates – rates may be low to begin with but may go up as time goes by. There may be fees associated with a home equity line.

In terms of home equity being used for fund higher education, if financial aid and other sources of funds are not available at better terms, and if the college education is likely to result in increased job prospects eventually allowing the borrower to pay the loan off, then yes.

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