For many Americans, home equity is their biggest single asset. That's nice, but is it an asset you can enjoy? Some people say yes, if you use a home equity loan to finance something you've always wanted--a dream vacation, a flashy sports car, or simply the opportunity to pursue a hobby.

As opposed to using a home equity loan to improve your property, which represents a form of investment, using it for something fun essentially means spending your home equity. That's ok--it's yours to spend--as long as you manage the risks responsibly.

Advantages of Financing with a Home Equity Loan

There are a few reasons why people are tempted to use a home equity loan as a source of financing:

• It is generally easier to secure financing for a secured loan.
• The interest rate on a secured loan is generally lower.
• Mortgage interest may have certain tax advantages.
• Using a home equity loan might be an alternative to dipping into tax-deferred savings, such as IRAs and 401(k) balances. 

Refinance if You Can

Under the right circumstances, a better option than a home equity loan might be to refinance your existing mortgage. If interest rates have fallen, you may be able to tap into home equity by replacing that mortgage with a new mortgage, equal to your remaining balance plus some portion of your home equity.

If you can refinance at a lower interest rate, you will be saving some of the interest expense on the remainder of the loan. Over time, the interest savings once you refinance may offset--in whole or in part--the new expenditure you are making.

Naturally, if interest rates have risen it makes more sense to take out a home equity loan than to refinance your existing mortgage. After all, why refinance and pay a higher rate on the entire mortgage balance when you can take out a new home equity loan and pay the higher rate only on the amount of the new expenditure?

Managing the Risks

Whether you refinance or take out a home equity loan, you must understand that the fundamental risk in any mortgage is that if you default on the loan, you can lose your home.

The best way to manage this risk is to make sure you have carefully budgeted for the repayment of the loan. Remember, just because you have the asset (in the form of home equity) available to borrow against doesn't mean you have the monthly cash flow to repay the loan.

There are other risks as well. Whether you refinance or take out a home equity loan, you are essentially committing to higher expenses in the future in exchange for more purchasing power today. This means foregoing some future purchases.  

Another risk concerns the tax advantage people associate with mortgage interest. Check carefully with your accountant before assuming this will apply, since there are conditions which can limit the deductibility of mortgage interest.

Home equity is a valuable asset which generally takes time to amass. As such, it's not something you should use for routine purchases, but if you truly view something as a once-in-a-lifetime opportunity, it might be worth assessing this financing option.

Source:

Internal Revenue Service