Home Equity Loan Traps

Consider how wealthy people view borrowing. They use debt only as a means to build more wealth, a philosophy foreign to many home equity borrowers. Here are some common second mortgage loan traps that serve as temptations to many.

A home equity loan has numerous tax incentives, and provides easy access to cash. Even with these perks, it's still debt, and not a cash windfall. If you're taking out a second mortgage, make sure that it's for the right reasons, and avoid the following home equity loan traps.

Using a second mortgage for investments

On paper, using a home equity loan to invest in the stock market might seem like a good idea. Why not take home equity cash, borrowed at approximately 8 percent, and invest it in a stock that will return 18 percent? This no-brainer maneuver has one catch: No investments can guarantee a return of 18 percent.

The only time that this type of move may be warranted is when you're launching your own business. Banks and other financial institutions are typically unwilling to lend cash to new ventures, so tapping your home equity might be your only source of capital.

Borrowing for an extra tax-deduction

A time-honored piece of advice from accountants is never to buy anything just for the tax deduction, which is meant to soften the blow of borrowing or spending money. In theory, this money is supposed to be used to improve the value of your home, or launch an enterprise. Borrowing only for a tax deduction, however, increases your debt. It doesn't make sense to spend a dollar just to save 20 or 30 cents on your taxes.

Consolidating debt

Propelled by the glut of debt consolidation offers on the market, many homeowners use a home equity loan to consolidate their debt. This maneuver only prolongs suffering-spreading out interest payments and, ultimately, costing the homeowner more in long-term interest. The key is to change your money management habits. Stop spending more than you earn, and use any savings to aggressively pay down that debt. It will be painful, but you'll be in better financial shape in the long run.

Pay for new luxuries

Life is short, so why not tap some equity and buy the car or boat of your dreams, or fly to Paris for a springtime vacation? Homeowners succumb to this temptation every day. Such spending may deliver short-term bliss, but it won't help you build long-term wealth. Instead of adding debt, try to create assets that will allow you to achieve the lifestyle of your dreams. Reckless spending will catch up with you eventually.

In our culture, debt is readily accepted, especially if it allows us to enjoy the lifestyle of the rich and famous. That motivation, however, is not a long-term, sustainable plan, unless you already are rich or famous. Tapping your home equity to improve your home, or launch a business, is justifiable. Otherwise, resist the temptation to take out a second mortgage.