|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
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
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