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Be Cautious With Home Equity Debt

Spring is the season when homeowners shake the money trees that they live in.

It's the time of year when people borrow against the equity in their homes: One-third of home equity lines of credit are opened from April through June as borrowers seek cash so they can fix up their houses.

But people don't spend their equity solely on home improvements. They use home equity loans and lines of credit to pay off credit card debt, to buy cars, to cover the kids' tuition and to pay for vacations. Now that the season for tapping equity is upon us, it's a good time to ask two questions: What are proper and improper uses for home equity debt? How much home equity debt is too much?

Four ways to tap equity

As a homeowner, you have four ways to tap your home's equity. First, you can sell your house, buy a cheaper one and pocket the difference. Second, you can refinance your mortgage, preferably at a lower rate, and borrow more than you currently owe and pocket the difference. As the refinancing boom winds down, that method is losing popularity.

The third way to extract equity is to get a home equity loan: a lump sum that you get when you take out a second mortgage. Nowadays, the most common way to turn equity into cash is take out an equity line of credit, which acts rather like a credit card. You withdraw money as you need it, and when you pay off the principal, the credit revolves and you can use it again.

With home equity loans, you're placing your home on the line," says Rudy Cavazos, spokesman for Money Management International, a debt-counseling agency with offices in 10 states. "If you default on this loan, you could lose your house."

That's what you have to keep in mind. If you default on a loan backed by your house, you can lose the house, even if you declare bankruptcy. On the other hand, if you default on a credit card, you can have all or part of the debt forgiven in bankruptcy.

The interest on much home equity debt is deductible from federal income taxes, which makes it tempting to use equity to pay off credit card balances and car loans. As Cavazos notes, you have to remember that you are risking your house when you borrow against your equity in it.

Before you tap your equity ...

"There are a few questions people need to ask themselves, or a few steps they need to take, before jumping in," Cavazos says. The first is to evaluate all the options, including selling things you don't need and borrowing against one's 401(k).

Second, he says, shop around for an equity loan or line of credit. Compare interest rates, fees and rate caps. If you don't understand the words and phrases the lender uses -- such as APR, rate cap and variable rate -- ask for a definition or bring along a knowledgeable person.
Next, ask yourself what will happen if something bad happens.

"Come up with contingency plans and scenarios," Cavazos says. "How about if my spouse loses her job? What if we become ill for more than 30 or 45 days? Do we have short-term and long-term disability insurance? You've got to think of all these things."

Article continued at http://www.bankrate.com/brm/news/loan/20030424a1.asp?page=default

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