6 smart ways to use a line of credit

If you believe the radio commercials, homeowners are sitting on a giant ATM, just waiting to fulfill their every desire.

Want to take a great trip, redecorate your house or buy a boat, but don't have the cash? Don't deprive yourself another minute! Use the equity from your house, have tiny monthly payments and deduct the interest on your tax return!

The part they forget to mention in those ads is what happens if you don't make the payments on a home equity loan or line of credit. Then you could lose your house.

That's why we asked nine of the wisest financial experts we know to help us come up with the six smartest ways to spend a home equity line of credit (and the five worst ways too.)

Let's set the stage by saying that a home equity line of credit is a powerful financial tool.

It works like a credit card. You have a limit to how much you can borrow, you pay interest on any outstanding balances, and as you pay down what you've borrowed, you have access to the cash again. It's relatively inexpensive to set up and as long as you don't use it, it shouldn't cost you anything to have it. (There could be an inactivity fee if you don't use it over a certain period of time, but some lenders will waive that fee, as well as closing costs and other fees. Always ask about them.)

Plus, the interest from a home equity line is generally tax-deductible, so it could help you at tax time. Talk to your accountant about your specific situation to see how it would apply to you.

Having instant access to all that cash can be dangerous, though, if you don't think it through before you write a check or swipe a card. Some people max out a credit line before they even realize it. Also, the interest rate is variable, so it can go up or down on a monthly basis. Even a change of a quarter of a percent can make a big difference in the monthly payment.

When's the best time to get a home equity line of credit? When you don't need one.

If you've been laid off from your job or you're in a bidding war on a vacation home, that's not the best time to go shopping for credit. You're under too much pressure and are likely to accept whatever terms you're offered. It's far better to get your credit line established when you're working and your finances are in good shape. Then, you can do some serious shopping to get the best terms and have it available if and when you need it.

So what to do with a home equity line?

  • Here's what we think:

  • Improve the value of your home.

This tops the list of all the financial pros as the best use of your home's equity. Use the money in your house to make your house more valuable.

You could update your kitchen or bathrooms, add on a bedroom and bath or family room, improve energy efficiency with new windows or an updated heating and cooling system, or preserve the structural integrity of your home with a new roof. If you're making the improvements with resale in mind, just make sure you don't price yourself out of the neighborhood.

Pay off high-interest credit cards.

If your credit card debt is at double-digit interest and you have trouble making the minimum monthly payment, then yes, it makes sense to use a home equity line of credit to pay off those cards and get out from under that debt.

The experts agree with us, however, that this is a one-time offer, folks. This is not an opportunity to run up the balances again. Pay off the cards, cut them up and cancel all of them except one. Keep the oldest one for emergencies only.

If you just don't trust yourself, then put the card in a safe deposit box or in a block of ice in the freezer. That ought to put a stop to impulse spending.

And don't forget for one minute that the collateral for this loan is your house. If you don't make the payments, the lender will foreclose on you.

Use it for a rainy-day fund.

Everyone should have emergency cash for life's unexpected events, such as a job layoff, a serious illness, a major home improvement or a car repair. That fund should have enough money in it to cover three to six months of day-to-day living expenses. Ideally, this should be cash on hand, sitting in a bank account earning you interest. As a Plan B, a home equity line of credit could be used to tide you over until life gets back to normal.

Buy a second home.

Many people have used the equity in their homes for the down payment on a vacation home or investment property. As investments go, this is a pretty good one because you're leveraging one appreciating asset to buy another appreciating asset.

You'll gain the tax benefits of the second property; if you plan to rent it out, those payments should cover your investment. The thing to remember is that a house is an illiquid asset, particularly in today's real estate market. If you get in a financial bind, you might not be able to sell it quickly.

Put your kid through college.

The experts have decidedly mixed opinions on this one.

On the pro side, it's a decidedly noble use of your money to help your child achieve his potential. You only use the money as it's needed instead of taking out a lump-sum loan, and there are tax benefits associated with the mortgage interest deduction.

But some experts oppose this for philosophical reasons, arguing that the student should be the one making the investment in his or her future.

There are many other ways to finance a college education and they think this will be a fitting introduction to the adult world.

There's also the risk that the student won't do well in school and the money will be down the drain. But all in all, we think it's a smart use of your home equity.

Start a business.

This one is at the bottom of the list because many businesses fail, and if yours did, it could put your house at risk.

The problem is that banks have historically been reluctant to lend money to new businesses and investors generally want to see your commitment to the business before they kick in their cash.

As a result, countless entrepreneurs have launched successful companies by borrowing against their homes. If you've done all your homework, have a solid business plan in place, a marketable product or service, and a supportive family who believes in your vision and ability to succeed, this is a way to accomplish that.

Many thanks to the following experts who helped us develop this information:

  • Dave Perry, senior vice president of Countrywide Home Loans.

  • Howard Dvorkin, founder of the non-profit Consolidated Credit Counseling Services and author of the book, "Credit Hell: How to Dig Out of Debt."

  • Diane Gray, director of counseling and education for Novadebt, a non-profit credit counseling agency based in Freehold, N.J.

  • Jim Bulger, president of the Pennsylvania Association of Mortgage Brokers.

  • Donald A. Taylor, Ph.D., CFD, CFA, associate professor of finance at American University in Bryn Mawr, Pa.

  • Bard Malovany, CFP, a financial planner with Sagemark Consulting in Annandale, Va.

  • Cate Williams, vice president of financial literacy for Money Management.

  • International, a non-profit credit counseling program based in Houston.

  • Brad Stroh, co-founder of the Freedom Financial Network consumer debt resolution service, San Mateo, Calif.

  • Charles Alexander, president of Alexa Corp., a financial services company in Cary, N.C.

By Pat Curry Contributing Editor

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