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Home Equity Loans: 3 Things You Need to Know

Credit: Flickr user nikcname.

When you're in need of some cash and you're a home owner, you might reasonably consider the option of home equity loans. With them, you borrow money based on the equity you've built up in your home (usually up to 85% of it) and pay the sum back in installments over a fixed period. A home equity loan is secured by your home, and the interest you pay is tax-deductible. That may sound great, but take some time to learn more before signing up.

You might want a HELOC instead
Keep in mind that there's another way to borrow against the value of your home equity, and that's through a home equity line of credit, or HELOC. While traditional home equity loans give you a lump sum that you pay back over time, HELOCs give you access to money in case you need it. It's especially handy if you want to know that you have a cash reserve in case of some emergency.

While home equity loans typically feature fixed interest rates, HELOCs tend to have variable ones, offering a low fixed rate for an initial period and then fluctuating with prevailing rates. (Some HELOCs can be converted to a fixed rate.) The rates can sometimes get quite high, so find out what the maximum is before signing anything. Indeed, find out all the details and terms before signing. Make sure, for example, that you don't have to withdraw any funds if you don't want or need to, and find out how much it will cost to set up the HELOC, too.

You can refinance home equity loans and HELOCs
We all know that mortgages can be refinanced, but home equity loans and HELOCs can also be refinanced. If prevailing interest rates for home equity loans are currently significantly lower than the rate on your loan, look into whether refinancing makes sense. (Be sure to take closing costs and other expenses into account when deciding.)

HELOCs, meanwhile, typically have an initial "draw" period during which you only pay interest, followed by an amortization period in which you pay off the principal as well, which results in higher monthly payments. Faced with this situation -- or, ideally, before it happens -- some folks take action. At Bankrate.com, Poonkulali Thangavelu offers three strategies:

  1. Refinancing the HELOC (which essentially starts the process over again with a new draw period).
  2. Taking out a new, fixed-rate home equity loan to pay off the HELOC.
  3. Refinancing the primary mortgage and incorporating the HELOC into it, getting a new fixed-rate monthly payment that tackles both debts

Obviously, you're at an advantage in an environment of low or falling rates.

You can use them to buy stocks -- but you probably shouldn't
Building equity in a home is a valuable thing to do, so only tap that asset if you really need to -- for example, if you need to perform major repairs or remodeling, pay college tuition, or perhaps consolidate other debts in one place with a lower interest rate.

Some have suggested borrowing against your home via home equity loans in order to invest in stocks, but that's a risky move. Sure, borrowing against your home and paying, say, a 5% interest rate seems like a great idea if you expect to earn an annual return of 15% in the stock market. Similarly, you might think you can't lose if you borrow at 5% in order to collect a fat 10% dividend yield. But returns are never guaranteed in the stock market, and dividends of all sizes can be reduced or eliminated. If things don't go your way, you could lose much of the money you borrow. Then you'll be left with less equity in your home and a bigger debt burden. Worse still, if you can't make your payment, you could lose your home.

Investing with borrowed money can be dangerous, whether you're taking out home equity loans or using a margin account at your brokerage.

Yet home equity loans are wonderful vehicles in certain situations. Read more about them to decide whether it makes sense for you to borrow with one. Remember that you probably have other options, too, such as taking some cash out in a refinancing of your home, consolidating credit card debt with a balance transfer deal, or perhaps just skipping that kitchen remodeling project for now.

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Selena Maranjian
TMFSelena

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter...

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