The Best Ways to Unlock Home Equity

Millions of homeowners regard home equity as something akin to a genie. Once they liberate it, it can solve many problems.

For instance, homeowners can use home equity for remodeling projects, paying off credit card bills, financing college, and investing. The main appeal of accessing home equity--such as home-equity lines of credit and home-equity loans--is that the interest rates are lower than traditional lines of credit and credit cards.

Used prudently, home equity can do many things, if managed carefully.

Home-Equity Loan Basics Home-equity (HE) loans offer low rates for a lump sum relative to unsecured lines of credit such as credit cards; you can pay back HE loans for as long as 20 years. Home-equity lines of credit feature variable rates, and you can take as much equity as you need--when you need it--up to a fixed amount based on your home-equity stake. Although use of home-equity credit has climbed since the 2008 meltdown, it has flattened out in recent years to about 4% of all outstanding credit, according to the Federal Reserve Bank of New York.

Both kinds of borrowing are tied into the ownership stake you have in your home--your mortgaged amount minus the principal payment total plus market value. At time of publication, for example, national rates on a $30,000 home-equity loan ranged from 4.25% to 8.2% for a homeowner with excellent credit (which translates to a FICO credit score of 750 or better), according to bankrate.com. In general, the higher your credit rating, the lower the rate of interest you will qualify for on your loan or line of credit.

Banks regard home-equity credit as "safe" borrowing, but there are risks to the borrowers. For example, unlike credit cards or installment loans, banks place a lien on your home with HE credit. If you default and can't pay off the loan, you could lose your house. There's also a nasty truth about home values that adds another level of risk to home-equity credit: As witnessed in the 2007-09 real estate meltdown, home prices can drop. When that happens, you could be underwater and owe more on your loans than your property is actually worth, which could lead to foreclosure. Many homeowners who lost their homes in the wake of the meltdown had home-equity loans on top of their mortgages. When jobs were lost, the loans only compounded the misery.

Uses of Home-Equity Loans, Good and Bad If you have sufficient home equity and rates on this kind of credit remain low, tapping into home equity may be a smart move for you. Here are some popular uses of home equity.

Pay off higher-interest debt. This could make sense if there's a large difference between the finance rates on your existing debts and home-equity loans or lines of credit (HELOC). "If you can refinance via a HELOC and that's a better aftertax rate given the term structure than the other debts, then that's a reasonable idea," says Michael Dubis, a certified financial planner based in Madison, Wisconsin. "But the better plan is: Don't get yourself into any debt in the first place. If you're now needing a HELOC to cover your other debt problems, my experience tells me that one may not be realistic about the more important goal which is long-term financial independence."

Invest in other real estate. This option has merit, but only if you have solid knowledge on investing in other kinds of real estate, such as multifamily/rental residential units or commercial or office property. There are myriad risks and costs associated with these kinds of properties. On the upside, if your rental income exceeds your costs, this income could be a consistent source of monthly or quarterly cash payments. You could even make money when you sell the properties--assuming there's been net appreciation.

Jeff Leventhal, managing director at HighTower Bethesda, Maryland, suggests investors consider private partnerships that buy and hold properties directly. Leventhal said partnerships have appeal because "leases on the properties have the ability to keep up with interest-rate increases. They make sense if you're looking for an alternative without the risk of stocks." To invest in these properties, you'll need to find a syndicator or advisor who specializes in them. Unless you hire a property manager or adviser, as a hands-on investor, you will need to vet every property carefully, tally all maintenance and related costs and charge rent that generates a profit. If working with an adviser, you will have to pay management/advisory fees and commissions. In any case, buying other kinds of property (other than single-family homes) can diversify your total portfolio while providing some income and a bit of diversification away from stocks and bonds.

Bottom line: Can be a good use of home-equity proceeds, if you have some knowledge of real estate.

Fund projects. When you take out a home-equity loan, you are going into more debt to raise cash today. Gauging whether this makes sense depends on how you use the money. If it's for a remodeling project that will enhance the value of your home, it's often a good decision. If you want to tap into your home equity to buy a vehicle or a boat, keep in mind that you're potentially purchasing a depreciating asset with borrowed money.

Bottom line: Can be a good use of home-equity proceeds, if you're funding a project that will add value to your home rather than funding a depreciating asset.

Supplement your retirement kitty. In most cases, tapping into home equity to build up your retirement kitty doesn't make sense. You'd have to take on more risk and need to exceed the cost of borrowing money from your home in your investment returns. Would buying government bonds make sense? Probably not--at least at current loan rates and bond yields. If a home-equity loan costs you 4% and a 10-year U.S. Treasury note yields around 2%, this investment doesn't make sense. What about stocks? If they are returning double digits, maybe, although there's no way to predict future performance and you're taking on market risk with borrowed money--always a dangerous proposition. "There's almost never a reason to tap equity in a home to use for retirement investing," says Dubis. "That seems to be an insanely bad idea for someone to do (especially at current market valuations). There's almost no comparison on the risk-free return versus portfolio risk discussion to do this."

Bottom line: Not a good use of home-equity proceeds.

Invest in an opportunistic stock portfolio. Using home-equity loan proceeds to invest in stocks was popular before 2008 and is being talked about again these days as the bull market in stocks goes into its sixth year. To some extent, the temptation to invest in stocks with these dollars is understandable. After all, over the past century or so, nominal real estate returns have roughly matched the rate of inflation, although when you subtract maintenance, taxes, financing, and other costs, homeownership performance rarely beats the cost of living over time, according to Robert Shiller, the Yale University economist, in his classic book Irrational Exuberance (see the new, revised third edition). Meanwhile, large-company stocks have grown at a compounded annual average rate of 10% since 1925, according to Ibbotson Associates, a Morningstar company. Small companies have done even better: 12% during that 90-year period.

To reap these returns, though, you need to be invested over decades. Moreover, stocks have sell-offs, corrections, and crashes, which are hard to predict. If you're tapping home equity to buy stocks, it's best to do that while share prices are cheap, although most investors are likely to do the opposite.

Bottom line: Not a good use of home-equity-loan proceeds unless you have a very long time horizon--or an accurate crystal ball.

Finance college. This may seem like the most attractive use of home equity for those with college-age children. You can get a good rate on a home-equity loan or line of credit. I know one family that did this to pay for their daughter's college degrees.

Yet, what seems to be convenient and low cost upfront can have some significant consequences down the road. Remember, tapping into your home equity may mean it takes you longer to pay off the loan. It also may delay your retirement, or put you deeper into debt. As you get older, it might be harder to earn the money to pay back the loan, making you less financially secure over time.

Most financial advisors will recommend that you have your child take on student loans rather than tap into your home equity to fund college. Your kids will have much more time to pay the loans back with a gradually rising income (some loans can even be forgiven if they're in a public-service profession), and your retirement won't be imperiled.

Bottom line: Not a good use of home-equity-loan proceeds, due to the risk to your own financial security and retirement.

Like any source of credit, you need to remain vigilant about home-equity debt. The Federal Reserve is still eyeing raising interest rates, which will make these loans less appealing. And don't forget that home prices don't always rise: You could end up underwater.

John F. Wasik is a freelance columnist for Morningstar.com and author of 14 books, including Keynes's Way to Wealth: Timeless Investment Lessons from the Great Economist. The views expressed in this article do not necessarily reflect the views of Morningstar.com.