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14% of millennial homeowners are poised to make a 'flashing red light' real-estate mistake: Expert

"Every expert I've talked to says it's a bad idea" to use home equity this way.

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If you're considering tapping your home equity for cash, it's hard to argue mathematically that now isn't a great time. Home prices have risen 20% in the last 12 months alone, according to the latest data released by Freddie Mac. Meanwhile, mortgage rates are hovering at a basement-low 3.3%, according to Bankrate.

High levels of equity among homeowners combined with low rates makes a move known as a cash-out refinance enticing: The move allows you to sign a new mortgage on your home (which has ideally appreciated in value) and take some of your equity in cash.

Although the move may make sense for you on paper, whether it's going to enhance your financers over the long term comes down to how you use the influx of money. And recent data indicates that younger people who own real estate may be faltering on this front. In a survey of mortgage holders from Bankrate, 14% of millennial homeowners (which Bankrate defines as those currently aged between 25 and 40) say they would tap home equity to pay for a vacation, compared with 4% of Gen Xers (currently aged 41 to 56) and 3% of baby boomers (currently aged 57 to 75).

One in 10 millennial homeowners said they'd use home equity cash to fund nonessential purchases such as electronics or a boat compared with 3% of mortgage holders from older generations.

"That was a flashing red light in the survey results," says Jeff Ostrowski, an analyst at Bankrate. "If you can't pay for these trips or items, do not use home equity — every expert I've talked to says it's a bad idea."

So if not to fund your next family trip to Disney World, what are the most productive uses for your home equity? Experts provide three options, below.

'The gold standard': Use the cash to improve your home

It can definitely make sense to use the proceeds from a cash-out refi to make necessary upgrades to your home: That's a no-brainer, says Ostrowski. "The gold standard is home improvement," he says. "If you need a new roof, a new HVAC system, if an electrical system needs to be replaced — anything that is going to improve the safety or structural integrity of your house."

Kitchen and bathroom remodeling projects are common uses as well, but borrowers aren't considered wealth-builders, says Greg McBride, chief financial analyst at Bankrate. "This is more of a wealth protection strategy," he says, noting that you're unlikely to achieve a dollar-for-dollar return on your investment when you sell the house.

The more dire the need for a renovation is, the more sense it makes, says Ostrowski. "If your kitchen was remodeled five years ago, it's not necessarily a good idea," he says. "But if you're looking at linoleum floors, go ahead."

You need to think of how a potential buyer is going to view your property after any given home renovation project is complete, he adds. "You don't want to over-improve a space to the point where it's out of scale with the rest of the house or the rest of the neighborhood," he says. "And avoid adding anything too quirky. The ninja course in the backyard or the man-cave you want are unlikely to be attractive selling points."

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A 'savvy strategy': Bolster your investments

You could also use home equity to invest in the stock market. If the fixed rate on a new 30-year mortgage you're signing up for is near the 3.3% average, you could theoretically come out way ahead over the next few decades if you invest in a fund that tracks the S&P 500, which has a long-term average return of about 10% per year. A more conservative investing approach could pay off, too. A portfolio of 40% stocks and 60% bonds returned an average of 8.2% per year from 1926 through 2020, according to data from Vanguard.

"If you make sound, long-term investments, this is a savvy strategy that disciplined investors can use to their benefit," says McBride.

There are dangers to this strategy, though, since markets can be bumpy, and past performance is no guarantee of future results. The key is to be mindful of the potential risks, says AnnaMarie Mock, a certified financial planner and wealth advisor at Highland Financial Advisors in Wayne, New Jersey.

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"If you think about March 2020, the markets plummeted and plenty of people lost their jobs and all of a sudden had no means to support themselves," Mock says. "If you lose your income stream at the same time that the market takes a downturn, you may have to sell those investments at a loss to make your mortgage payments. You have to think about those kind of circumstances before making this move."

You'd be wise to tamp down on huge swings in the portfolio you're putting money into, says Ostrowski. That means holding a diversified portfolio of low-cost funds and avoiding big bets on risky assets. "If you're using this money to try to pick individual stocks or invest in the crypto boom, that's a tough strategy to hit constantly or repeatedly over long periods," he says.

A simple strategy that 'makes sense': Pay down debt

Tapping your home equity to pay down high-interest rate debt is another straightforward calculation for homeowners. The average interest rate on credit card debt, for example, is north of 16%, according to Bankrate. Paying that debt down with cash from a mortgage loan that you're getting in the low single-digits is likely going to allow you to get our of debt faster and pay less in interest overall, says Ostrowski.

"This strategy makes sense with one caveat," he says. "You need to make sure you've addressed the underlying issues that led you to credit card debt in the first place. If it was a one-off thing like a medical emergency or a job loss, go ahead. But otherwise, you can find yourself back in the same situation you were in before."

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In fact, you could be in a potentially worse situation: still in major credit card debt and now out the chunk of equity that you extracted from your home. To avoid this scenario, set up a budget you can stick to in order to curb habits that may lead you to overspend.

Don't use any of the money you've taken out on frivolous expenditures that could hurt your bottom line, says Ostrowski.

"If you took out $30,000 and your home renovation or debt repayment costs $29,000, and you use the other $1,000 to go to Disney world, fine," he says. "But don't use the money to pay for a cruise or a boat or a gaming console that's going to be outdated in the next few years. You're paying for these things for the next 30 years."

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