5 Things to Consider Before Investing with a Home Equity Loan

Home Equity Loans are available to individuals who have accumulated equity in their house – in other words, to those homeowners who owe less on their mortgage than the market value of their house.

Home Equity Loans are a form of secured debt, with the underlying dwelling staked as collateral, and this frequently results in lower interest rates and more favorable terms attached to a home equity loan than to unsecured forms of debt such as credit cards and personal loans.

The combination of many residential real estate values surging beyond old highs set prior to the Great Recession along with attractive low interest rates available to borrowers make the prospect of leveraging home equity through a home equity loan a potentially interesting proposition for those seeking additional funding.

Given the current low interest rate environment and the rise in housing prices, an interesting question that some potential borrowers may ask themselves is whether proceeds from a home equity loan should be used for investment purposes. So, is it a good idea to use a home equity loan for a side investment? Let’s take a closer look.

A 2018 study conducted by LendingTree revealed some interesting trends related to how home equity loan borrowers allocated funds accessed through home equity loans. Just under 43% used the funds for home improvement, while using funds for debt consolidation ranked a close second at 38%.

Meantime, the study found that just over 8% of borrowers used proceeds from home equity loans for investment purposes, including those borrowers who invested in real estate and had the highest average loan amount of all, at just over $103,000.

San Jose, California took the top spot geographically for using home equity loans in real estate investment, showing a whopping median loan amount of $300,000, while also taking the top spot in using home equity loan proceeds for other investment purposes, posting a robust median loan amount of $160,000.

Clearly, and especially for some in San Jose, there are proponents who believe in the virtue of using funds from home equity loans for investment purposes. But, is doing so a good idea for you?

The idea that proceeds from a home equity loan can be used for investing in a small business, real estate flipping, income-producing real estate, the stock market, higher education, or for some other investment is predicated on seeking to earn a profit that exceeds the total cost of the loan.

This can only be approached following thoughtful consideration of all costs, risks and associated pitfalls of the potential investment. Costs of the loan go beyond evaluating total interest expense to also include closing costs and other fees.

Then the type of investment and its associated costs must be added to the equation as well – for example, if one seeks to flip real estate, there will be a cost of carrying the property between the time of initial purchase and the time it is sold. Execution risk must also be taken into consideration and whether the potential return is truly worth the uncertainty.

Furthermore, while some investments can have quicker turnaround times, others may take longer to execute upon, with interest expense on the home equity loan accruing all the while.

One of the more common approaches toward using proceeds from a home equity loan for investing purposes involves investing in a small business. In general, qualifying for a small business loan is more difficult than securing a home equity loan, and this is before considering that the interest rate and terms associated with a home equity loan will often prove more favorable.

The relatively easy access to inexpensive funding through a home equity loan can be enticing to small business owners or those looking to invest in a small business, but it is important to know that approximately 50% of small businesses cease operating within five years, so it is vitally important to have a contingency plan in place in the event that things don’t work out as planned.

In a similar manner, investing in the stock market comes with its own risks that must be evaluated prior to taking home equity loan proceeds and putting them to work in the market. While historical S&P returns trend toward the high-single digits, it is only through taking a multi-year long-term approach that one can hope to mimic this past performance, which is never a guarantee of future results.

When it comes to financing higher education, it can often be the case that a Federal student loan will come with similarly attractive interest rates as those that come with a home equity loan, while also offering access to flexible repayment plans. Therefore, investing in higher education via proceeds from a home equity loan isn’t necessarily a wise option if Federal student loans are also accessible.

When it comes to real estate investment, whether it’s buying an income-producing property or attempting to flip properties for a relatively quick profit, only participants with a deep understanding of the local market in which they seek to participate should consider the venture – the risks are simply too great for the ignorant.

Therefore, a full understanding of pricing conditions and repair costs, as well as access to the most trustworthy contractors and the cash flow to carry expenses for as long as necessary before an eventual sale will close, is essential prior to going in on the investment.

Turning to investing in home improvements – this can be potentially profitable if proper research is conducted to determine the types of improvements that have historically been most profitable in your area. Timing can matter as well, as it is often the case that home improvements performed within twelve months of an eventual sale of a property result in a greater return on investment.

Remember, because a home equity loan is secured by the underlying property serving as collateral, it is vitally important to make timely repayments. Failure to do so can result in foreclosure – so before considering any investment, design a plan that will allow you to pay back each month no matter how successful or unsuccessful the investment eventually becomes.

This can mean borrowing less than originally planned, but regardless, you should not borrow more than 70% of the value of your home, so as to provide important leeway in the event that property values decrease in your area.

Do not base the size of your home equity loan on the hope you have for the potential performance of any investment. Instead, the amount you borrow should be based upon what you can afford regardless of how the investment performs – in other words, base the amount on what you could pay back each month if your investment were to provide you with no return whatsoever.

Steven Brachman is the lead content provider for UnitedSettlement.com. A graduate of the University of Michigan with a B.A. in Economics, Steven spent several years as a registered representative in the securities industry before moving on to equity research and trading. He is also an experienced test-prep professional and admissions consultant to aspiring graduate business school students. In his spare time, Steven enjoys writing, reading, travel, music and fantasy sports.

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