Updated on 09.11.14

Need a Home Equity Loan? Answer 3 Questions First.

Trent Hamm

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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  1. boomie says:

    When the basement room is done he still will have to go out and buy that big screen plus furniture. How will he pay for that? More loans?
    Suppose something happens to him and/or he can’t pay the additional loan/loans? He runs the risk of losing his home all because he wants a man room and a big screen TV N O W!!!
    He doesn’t have to wait or save for 4-5 years to do the room. He can do what I call ‘paycheck remodeling’. A little bit each week or month and get the job done slowly. It could be finished in a year or two. Also, construction costs are always 3X more than planned. He may borrow $25,000, costs may equal $35,000, he may not have the money anyway and the man room may not get done.
    My comment is this: people shouldn’t get equity lines of credit in the first place. That’s your savings/retirement account. Your home is NOT your bank.
    Sounds like this guy is going to do whatever he wants anyway. Let him do and then just sit and wait till you can say “I told you so”.

  2. Wendy says:

    After reading this entry’s first paragraph, I continued somewhat warily. We are at the tail end of completing a kitchen remodel that ended up costing 2-3 times our initial guess (we knew this remodel was a must when we bought the house last year). Luckily, we bought a less expensive house than we could have afforded so we could do this sort of ‘upgrading’ to our own taste. We also paid for half of the remodel in cash. In the end, I was happy to see that we meet at least one of Trent’s qualifications =).

    I think he should do more ‘can I afford it?’ segments- it is my favorite part of the suze orman show.

  3. George says:

    What are the other two questions? I only see three…

  4. shawn says:

    trent, i blafsred you the other day, but this kind of post iis when you are at your best. the only quibble i have is that you neglected taxes including your calculations. he will save his marginal tax-rate on the home equity interest and pay it on the savings income. otoh that doesn’t make this a wise decision and i agree with your conclusions and reasoning.

  5. j dawg says:

    You should remove the Debt reduction part of the qualification from the equation. You can not borrow your way out of debt. I know you qualified that there has to be a commitment to not run up the cards, but it is such an important point. You can not borrow, trick, or magically get your self out of debt. I am a firm believer in that you have to go through the pain so it forever imprints on you not to do it again.

  6. Marcus Murphy says:

    Depending on how interested he is in DIY his expenses should be as follows:

    Sony 70″ 1080p HDTV

    Sony Full HD 900W Surround Sound

    Toshiba A2 HD-DVD Player

    Mini Fridge $200
    Wine Cooler $150

    Sofa Set: 2 Sofas, Loveseat, Chair, Ottoman


    Hammer drill/Angle Grinder with accessories

    Makita 10″ Miter Saw with Laser Guides

    Misc. Materials Costs $6,000

    Total Aprox. Cost ~$15,000

    In about 2 years and with the help from a new 0% card (for when you need to buy more than $482/mo. to continue the project) and having a fun project on your hands, he can save ~$15,000 out of pocket. He can save another $2,000 by going with a screen 10 inches smaller.

    If it were me I would start out by applying for a new 0% card, spend $3,000 on the electronics and pick up a bargain rug somewhere and some used furniture and start the den that way. Any money left on the card would go towards buying first the tools and then the materials to start building up the floor and then the walls. Then just sock away the money in a savings account and pay the minimum payment on the card. When the intro period ends, use the saved up money to pay it all off. Cut up card, rinse, repeat, until the project is finished.

  7. Debbie says:

    I have to point out that after your friend puts his $483.32 into an HSBC Direct savings account, although he might have his $25,000 in less than four years (depending on how interest rates fluctuate), costs are likely to have increased by then due to inflation, so he won’t be done saving. (Although the TV will probably be cheaper, better, or both.)

    That said, I’m saving for the remodeling I want. (I want a screened-in back porch, a laundry room, and a dishwasher, and will also look into other upgrades to bring the house into the 21st century.)

    I like Boomie’s paycheck remodeling idea. (In my case I would first hire an architect to make a long-term plan. Then I’d build the laundry room and/or porch, moving the washer out of the kitchen into the laundry room, and putting some shelves or a baker’s rack in its place. Then yank out the cabinet next to the sink, put in a dishwasher, put in a cabinet where the clothes washer used to be, and put in a new countertop of the appropriate dimensions. Any re-wiring, flood-proofing, storm-proofing, etc., would be done at the most efficient phase of the process.)

    Another idea is to put some or all the money in the stock market, since the timing is not important–good returns may allow for an earlier remodel, though bad returns will require putting it off even longer.

  8. Erin says:

    You make an excellent point Trent. Recently Money Magazine pointed out that finished basements, meaning drywalled, painted, and maybe carpeted if I remember correctly, boost the resale value because buyers can better visualize the use of space. But this guy is going way overboard!

    If he’s married, you might also suggest that he consider how his wife is going to feel about all his male friends coming to the house to hang out all weekend. She may have some thoughts on the issue. If he doesn’t have a wife, why can’t the guys just hang out in the living room?

  9. 60 in 3 says:

    I made the mistake of opening a line of equity when I remodeled my house. Initially, I just used it for things like contractors and such. That would have been fine since the work I was doing to the house increased its value beyond the cost. However, I soon started using it for things like electronics and entertainment. At that point, it became nothing more than another source of unneeded debt.

    I learned my lesson. Lines of Equity should be used wisely. They are a great source of potential cash, but they shouldn’t be treated as free money. You are quite literally spending the equity you worked long and hard for.


  10. Will he be in the same house in 4 years?

  11. Doug says:

    I agree with Marcus Murphy. I recently completed a DIY basement conversion for less than $6000.00 including hiring out the concrete floor and most of the wall construction. I now have a nice office for myself, a computer desk/play area for my daughter and a tv watching area with a couch and several chairs. Right now we are using an old 27″ TV from upstairs but soon I’ll have the cash for a 42″ LCD flat panel.

    None of this type work is difficult at all and from a contractors point of view none of the work is structural so you can only mess up so badly.
    I might even be willing to bet that if he had the cash for the materials, to start immediately, he could be finished with this project working nights and weekends before the average remodeling contractor would be finished.

  12. ShootDawg says:

    If someone does decide to get a home equity loan, they should get an actual loan, instead of the line of credit.
    The line of credit is bad, in that it would allow the person to continue to draw money from the loan, as they pay it back. Borrow $10k, pay back $5k over two years, draw another $3k out of the line of credit, etc.
    The straight-up loan would give you all the money up front, have a set payment each month, and not allow you to continue to draw money from the account.

  13. Ted Valentine says:

    I agree with your perspective, but the room will cost $30-$35,000 in 5 years.

  14. rsquared says:

    My husband sells sunrooms. We are also looking into finishing our basement which we have yet to save a dime for. I showed him this article and he immediately said, “That guy is dead wrong”. He said in 5 years the construction will cost much more then it will today probably to the point where you’re saving money by having an equity loan and paying over 5 years. The sunrooms he sells have gone up about $5000 in 2 1/2 years on an average room because of rising gas prices and rising material costs. I personally like the idea of doing it yourself paycheck by paycheck.

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