Need a Home Equity Loan? Answer 3 Questions First.

One of my closest friends has been itching to turn half of his basement into a den of sorts, with a full bar, a big screen television, a few couches, and a few card tables. Basically, he wants to have a “hang-out” place for a lot of his male friends on the weekends to watch sports. He’s found a lender who will loan him more than enough to build this room just as he wants it at a 6% rate and he basically asked me about it, hoping that I would give the big thumbs-up.

I didn’t. I told him to save the cash for the room rather than committing to another regular payment. Needless to say, he didn’t like the advice and is still going through with the loan.

My advice to him was to ask himself five questions before he took out a home equity loan. If he could not answer yes to any of them, then he shouldn’t be taking out the loan.

Is it a truly necessary expenditure? The key word here is necessary. If you total your car and only have liability insurance, it might be time to look at a home equity loan. If your child burns his arm and needs skin grafts that aren’t covered by your insurance, get that home equity loan. On the other hand, if you want to build a home theater because it would be “awesome,” that’s not a necessary expense by any stretch of the imagination.

Does it increase the value of your home at least as much as the value of the loan? A kitchen remodel might do this and a bathroom remodel has a chance of doing this, but putting a giant den in the basement? Probably not. If you want to do fun things like that, save up and do them yourself – it’s cheaper in the long run and does increase the value of your house somewhat (and definitely ups the personal “fun” factor).

Does it reduce your overall debt burden? For example, I know one person who took out a 6% home equity loan to pay off several 20% credit cards, drastically reducing her annual debt burden. Of course, this really only works with a commitment not to run up more credit card debt.

This leaves one final question, what do I do if I have a big expenditure that doesn’t fulfill one of these categories? If it’s not a requirement, doesn’t increase your net worth, or doesn’t lessen your debt burden, you should be saving up to make the move. Plan for it now and keep tweaking that plan, but set up a savings account where you can sock that money away. Make it regular – have an automatic deduction from your primary checking account – so you can plan around that financial build up.

Want to see an example? My friend estimates that his room reconstruction will cost $25,000. If he took out a home equity loan at 6% over five years to pay for it now, he would have to make monthly payments of $483.32 for the next five years to pay it off, a total cash outlay of $28,999.20. On the other hand, if he started putting $483.32 into a HSBC Direct savings account each month right now (which earns a 5.05% APY), he would have his $25,000 in that account in less than four years (three years and eleven months to be exact). His actual cash outlay for the room would be $22,716.04. By showing restraint, my friend would save $6,283.16.

Alternately, one could sock away only $362 a month into that HSBC savings account and have the $25,000 in five years. This basically just means that you reduce your payment by more than $120 a month by simply being patient about the room.

But I won’t get it now! One argument that people would use here is that the extra $6,283.16 you pay is worth it because you’ll get to enjoy the room for four years. Essentially, you’re agreeing to pay the bank $133.68 a month in rent for the first 47 months just to have this room now. That’s about as financially unhealthy as can be – you’re essentially adding another hefty bill to the pile of ones that already exist.

Remember, every single monthly required bill you have means less money you have to invest and move towards complete financial freedom.

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