Aug 2, 2023
In today’s roiling economy, fluctuating interest rates and inflation are leaving many people in a cash crunch. So it’s little wonder that some people are turning to personal or business loans to see them through tough times. And for many borrowers, the question then becomes: what to use as collateral on the loan?
“In recent years, homeowners have increasingly turned to using their homes as collateral for loans, largely driven by rising home equity,” says Trey Nantz, a real estate attorney at the South Carolina–based Nantz Law Firm.
But as black and white as the situation appears at first glance, there’s plenty of gray. So we tapped finance pros to help us unpack why homeowners are tempted to use their homes as collateral and what pitfalls to watch out for.
Reason 1: Educational purposes
It’s no secret that higher education comes with a high price tag. Private undergraduate colleges cost around $39,400, while public colleges run between $10,950 and $28,240 a year, according to the latest numbers from the College Board. But an investment in education is an investment in your—or your child’s—future.
And most experts agree that using your home as collateral to fund education is a worthy cause. But you want to ensure that paying that loan back won’t be an issue.
The fine print: Ben Gold, founder of Recommended Home Buyers in Philadelphia, worked with homeowners who used their home as collateral to fund their child’s education.
“Although this allowed them to secure the necessary funds for tuition and related expenses, they faced difficulty in repaying the loan during a period of job loss,” says Gold. “Their inability to meet the loan terms ultimately resulted in the loss of their beloved family home.”
Reason 2: Funding a business
Entrepreneurs often use their home as collateral when applying for a business loan. But that route is a good idea only in certain cases.
“Many people starting their first business do not understand the demands, sacrifices, and problems of starting a business, which is represented by the high failure rate,” says Bruce Ailion, a real estate agent and attorney with Re/Max in Atlanta.
So instead of using your home to guarantee a loan, Ailion recommends finding a partner or investors with money to risk—and potentially lose.
The fine print: Using funds to expand an existing and successful business, however, is a viable and worthy use of your home equity, Ailion says.
And never use home equity to…
The list of loans that you should seriously consider not using your home as collateral for is long. But according to the experts, there are certain repeat offenders—almost always tied to emotions—that experts say homeowners should never even consider.
“People make bad choices pledging home equity for a boat, car, truck, vacation, wedding, or funeral they can’t afford,” says Ailion says. “Inevitably, these savings will be lost.”
If you do plan to use your home as collateral…
If you feel like you have good reasons for using your home as collateral, proceed with caution and keep the following guidance in mind.
Jay Garvens, a business development manager for Churchill Mortgage in Colorado Springs, CO, advises potential borrowers to make sure they can pay off and close out the loan within six to 18 months.
Having a repayment schedule is crucial, especially when interest rates can spike, he adds. “I’ve seen cases where borrowers failed to pay off a line of equity before the prime interest increased. And in recent months, that’s meant that their rates jumped from 3.75% to as high as 9.75%.”
For one of Garven’s clients, that rate hike saw the monthly repayments skyrocket from $865 to a whopping $2,025 per month.
Consider the worst possible scenario
Before agreeing to use your home as collateral, consider what you’re putting on the line.
The most serious risk is the potential for foreclosure, meaning that homeowners could lose their primary family home if they’re unable to repay the loan.
“For the average homeowner, their home represents not only a refuge and place to live but also their most valuable asset, their nest egg,” says Ailion. “When someone retires, it’s often their only asset to sustain them in retirement. As such, a home should be seen as a last refuge for putting at risk of loss.”
And according to the Federal Trade Commission, using your home as collateral can be an exceedingly dicey proposition. The FTC’s warning is stark: “Don’t let anyone talk you into using your home as collateral to borrow money you may not be able to pay back.”
The advice continues: “Not all loans or lenders (known as ‘creditors’) are created equal. Some unscrupulous creditors target older or low-income homeowners and people with credit problems. These creditors may offer loans based on the equity in your home, not on your ability to repay the loan.”
Bottom line: Proceed with caution if you decide to use your home as collateral on a loan. Your home is likely your biggest asset, and you don’t want to risk losing it. So ensure you can repay the loan promptly before you sign on any dotted lines.