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3 ways to use your home equity for 'long-term wealth creation'

"These are higher risk strategies, but they can pay off for a savvy and disciplined investor."

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You may have more cash in your house than you think. No, not under your mattress or in the attic (although if that's the case, consider a bank account instead), but in the form of your home equity. If you own a home, you may be able to perform a cash-out refinance, which allows you to sign a new mortgage on your house and take some of the equity out as a lump sum. 

That's an appealing prospect for current homeowners, who have record-high equity to tap thanks to a 15% runup in home prices, according to Zillow. Meanwhile, mortgage rates continue to hover near record lows, meaning you're likely to lock in your new mortgage for a bargain price.

Once you have the extra cash on hand, you may be tempted to invest it in the market. After all, the numbers add up: If you borrow against your home at a rate of 3.5% and earn a long-term return of, say, 8% in the market, you're coming out way ahead.

Still, investing the proceeds from a cash-out refinance can be risky, experts caution. If you plan to live in your house for a long time and have other robust income streams, the move can be a lucrative one. If not, you run the risk of being forced to sell your investments to pay your mortgage, which could trigger losses in your portfolio.

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Investing isn't the only option, though. Read on for three more common uses for your home equity that can benefit your finances over the long term. None of them are foolproof, says Greg McBride, chief financial analyst at Bankrate. But with careful planning, all could pay off big.

"You have to be disciplined in the application of these funds," he says. "If you're using the funds for long-term wealth creation, these are higher-risk strategies, but they can pay off for a savvy and disciplined investor."

Pay off high-interest-rate debt

The math behind paying off debt with a cash-out refinance is similar to that of investing the money. If you take out a loan at 3.5% and use it to pay off credit card debt, which comes with an average interest rate of about 16% according to Bankrate, you're going to cut your interest costs and get out of debt faster, says McBride.

Assess your spending carefully before making the move. "The big question is, have you addressed the root concern that accumulated that debt in the first place?" he says. "If you haven't fixed the root cause of overspending, you'll find yourself in the same situation with high-rate debt — but now, you don't have the equity."

If you know that you're prone to overspending, take some time to create and maintain a budget you can stick to before taking on any new debt in the form of a mortgage. And if you're worried you may find yourself dipping into the negative, consider adding a side hustle to boost your income and give yourself some breathing room.

Invest in real estate — or a renovation

Putting the money toward a down payment on a rental property can be a great way to generate consistent passive income. But the strategy comes with a unique set of risks, says AnnaMarie Mock, a certified financial planner and wealth advisor at Highland Financial Advisors in Wayne, New Jersey.

"Now you're a landlord, and you have to make sure you have 100% capacity," Mock says. "There's a risk your tenants move out. You could have a loss of that income, and then you have to cover higher payments on the home, plus operating expenses for that property."

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A less risky option is to invest in improvements to your current home. "Making improvements to your home presumably enhances its value, and if you did need to sell your home, you could recoup those costs in some way," says Danielle Hale, chief economist at Realtor.com. "Most remodeling will return 70% to 90% on your money."

It's also a way to protect the value of one of your biggest assets, points out McBride. "Most home renovations won't return dollar-for-dollar," he says. "But you're not going to get the current market value of your house when you sell if it needs a new roof."

Invest in ways to grow your income

Rather than investing in stocks or real estate, which are subject to unpredictable market forces, consider spending the money on enhancing your potential to earn more down the road. "You could take it out to start a business or help with college costs," says Hale. "These are the types of investments that are a little more guaranteed."

Of course, not every business idea is a surefire winner. Entrepreneurship experts generally recommend taking on as little debt as possible to get your business off the ground: Even if it's a success, it can sometimes be years before it generates a steady income. "Using [home equity] to start a business can be precarious," says Mock. "There are other types of loans out there that won't put your home at risk."

In other words, if you want to use your home equity as seed funding for a business, make sure you don't quit the day job that will allow you to consistently pay your new mortgage.

You could take it out to start a business or help with college costs. These are the types of investments that are a little more guaranteed.
Danielle Hale
Chief economist, Realtor.com

A safer bet is paying for education, either for yourself or a child, says Hale. "We know that people with degrees tend to earn more income," she says. "Sending yourself or someone else to college is a surer way to enhance their income in the future."

This strategy isn't without its pitfalls, though. Even if your mortgage loan comes with a lower interest rate than a student loan, those debts are handled differently if you fail to pay them back. While failing to repay your student loans can hurt your credit score or, depending on your circumstances and the type of loan, result in bankruptcy, failing to repay your mortgage could result in the loss of your home.

"You can pay back home equity debt with income, or you can sell your home to pay it back. But since that's where you live, that's not what people envision," says Hale. "If you put [the lump sum you take out] in something that will generate income and pay your loan back with income, you're going to end up with more wealth in the future."

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