Using Home Equity as a Piggy Bank

As mentioned in my previous articles on Debt, historically low interest rates have fueled an unprecedented increase in personal borrowing and household debt. One significant component of this debt is real estate mortgages and debt secured by real estate. To make matters worse, many people make poor decisions regarding the use of equity.

Equity in your home is the difference between its market value and the balance on any mortgage. Once home equity is accumulated, there are several ways to use it to your advantage. However, careless use of this equity can result in unexpected financial problems.

Traditional Mortgage

The traditional real estate mortgage was used primarily to finance the purchase or construction of a home. There was generally some initial equity in the residential property as a result of a significant down payment, pre-owned land or contributed labour.

Second Mortgage

Eventually, second mortgages became widely used. A second mortgage allows the equity in a home to be used as security to finance a major project such as home renovations and upgrades. This financing approach can be effective and rational, because the investment will result in an increase in value of the home.

Line of Credit

In the last 3 decades, a financing option known as a Line of Credit (LOC) has become increasingly popular. A LOC can involve significant amounts of debt, with the credit limit pre-approved and the monthly payment based on a percentage of the current balance, often 2 % or 3 %. The amount of approved credit on a LOC can be greatly increased by securing it with the equity in your home, which may also provide a reduced interest rate. If used properly, this type of credit can be a great financing and budget tool.

However, misuse of a LOC can contribute to major financial problems. If the credit limit is maxed out by imprudent spending, you have only added to your mountain of debt. If your maxed out limit was secured by your home equity, you may have even greater problems.

Home Equity Piggy Bank

The practice of using the equity in your home to secure a LOC is often referred to as using your home as a piggy bank. When using the LOC, you are making purchases with money that you have put into your home over the years and putting it back through monthly payments. This is not necessarily a bad thing, if the money is used to maintain or renovate your home.

However, if the funds from a home equity loan are used for other purposes, such as purchasing large ticket items, you must consider the fact that you are financing these items over an extended period of time. It is generally unwise to finance items such as furniture and appliances, recreational vehicles, or boats over a long period. Such items will likely have worn out or deteriorated well before the related debt is paid and the long-term interest cost will be enormous.

Even more ill-fated is the practice of using funds from a home equity loan, whether it is a second mortgage or a LOC secured by your home, for normal household consumption. Using these funds to purchase groceries or pay monthly utility bills is a recipe for financial disaster. Never use long- term debt to finance short-term expenditures. The results of such behavior are frequently seen in the form of credit problems, ranging in severity from delinquent payments to personal bankruptcy, and would be poor use of your home equity.

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