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Home Equity 101

Want to pay off high-interest debt in one fell swoop? Searching for ways to pay for a basement renovation, a bathroom upgrade, or a new tile roof? Since you probably don't have that kind of money stuffed under your mattress, a natural place to look for more funds is in your single biggest asset: your home.

But before you tap into those funds, you need to know exactly what you're getting into. Putting your home at risk isn't for the uninformed or undisciplined.

Home equity loan vs. home equity line of credit
The first step to tapping into your home equity involves understanding your options. There are two major ones: a home equity loan (HEL) or a home equity line of credit (HELOC). Here's a handy guide to the basic differences between the two, including pros and cons.

Helpful tips on the HEL
A home equity loan is, at heart, a second mortgage. You receive a lump sum at a fixed rate of interest that's locked in when you procure the loan. You're expected to pay it back in fixed monthly payments for a fixed amount of time -- typically 10 to 15 years.

Pros:

  • Your interest rate is fixed, which means no shocking increases later.
  • Because payments are due monthly, this can be a good option if you have a hard time exercising the discipline needed to pay off a loan a little at a time on your own.
  • The interest rate on a HEL, though higher than that on your primary mortgage, will still be lower than the rates available on credit cards.
  • If you're using your HEL to pay off credit cards, in addition to lower interest rates, you'll have the benefit of consolidating all your debts into one payment.
  • The interest on your home equity loan may be tax-deductible, but you'll want to thoroughly read Publication No. 936, the IRS's guidelines on the home mortgage interest deduction, to ensure the degree to which you're eligible. If your loan is for home-improvement purposes, rather than, say, college tuition, you're allowed even greater leeway in deducting the interest.

Cons:

  • You borrow (and owe interest on) the whole amount, rather than being able to simply borrow what you need.
  • If you're using the equity to fund something that will involve multiple payments over time -- say, for example, a phased home-improvement project or quarterly payments on college tuition -- you'll have to be sure not to spend the money on other things in the interim.
  • If you use your HEL to fund something that immediately depreciates, such as a car or new furniture, you may hurt your net worth in the long term. Boosting the value of your home has a better chance of enhancing your overall financial picture over the long haul.
  • You may be prohibited from renting out your home, according to your loan terms.
  • You risk losing your home if you can't make the payments.

Hello, HELOC
A home equity line of credit, by contrast, functions more like a credit card -- using your home as collateral. You ask for a line of credit, and the lender assigns a maximum amount you can borrow -- a credit limit. Lenders typically determine this amount by taking a percentage of your home's appraised value and subtracting the amount you still owe on the mortgage; then they factor in things such as your credit history, debt load, and income. The lender then gives you a set of blank checks or a credit card that you can use to withdraw funds.

Unlike a HEL, the line of credit allows you to borrow what you need, when you need it, up to the full amount approved. So why wouldn't everyone want to apply for a HELOC in case an emergency strikes? Take a look at the pros and cons to see for yourself.

Pros:

  • You don't have to borrow in a lump sum; you can withdraw the funds when you need them.
  • HELOCs can be used as emergency funds in the event of a crisis, like losing your job, since you can access funds on an ongoing basis as needed.
  • Some lenders may allow you to convert to a fixed rate of interest, or to a fixed-term installment loan, for part or all of your balance.
  • The rates of interest, though variable, may still be lower than other forms of consumer credit, since they are secured with collateral -- your home.
  • The interest on your HELOC may be tax-deductible, just as it is for the HEL, but consult IRS Publication No. 936 for confirmation of what applies to your particular circumstance.

Cons:

  • HELOCs typically have variable interest rates tied to the prime rate, so you could end up owing a much higher balance than you had anticipated.
  • The terms of a HELOC may dictate that you must begin withdrawing funds within a certain time period, and that you withdraw a minimum each time.
  • The costs of securing a HELOC aren't pocket change. Expect to pay for a current property appraisal, an application fee, closing costs, and other possible charges, including points on your loan. You may also be subject to transaction fees every time you withdraw money.
  • Though the HELOC offers flexibility in terms of when you withdraw funds, there is no flexibility in terms of the end date. When the term of your loan expires, the balance of the loan is due in full. If you procrastinate or have difficulty making regular payments over the long haul, you may be hit with an excessively large bill at the end.
  • Lenders make it very easy to access the funds; you have to be disciplined enough to resist unless there's an emergency or a planned expenditure that's worthy of risking your home.
  • You may be prohibited from renting out your home, according to your loan terms.
  • You can damage your credit and lose your home if you're unable to repay on schedule.

Conclusion
Before you rush to apply for a home equity loan or line of credit, first give serious consideration to whether you really need the funds. The terms can sound enticing, and the money seems relatively easy to get, but it all may be too easy. If you've ratcheted up high-interest debt and now see your home equity as a way to deal with the problem, you need to recognize that the loan is just a temporary fix. Clearing the decks so you can start spending again will be destructive to your financial health.

Whether it's a HEL or a HELOC, consider yourself a good candidate only if you have the discipline to use the funds for a dedicated purpose, you're spending the money on something of vital importance, and you can repay on time. If that's you, tapping into home equity can be a useful strategy for accomplishing your goals.

Fool contributor Elizabeth Brokamp is a licensed professional counselor with a special interest in Robert Brokamp, editor of The Motley Fool's Rule Your Retirement newsletter service.


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