Should You Take Out a Home Equity Loan?

Should You Take Out a Home Equity Loan?

The era of the second mortgage is back. Or at least it’s getting there. After a six-year slump, Americans are dipping into the rising equity in their homes for newfound cash.

Home equity loans and lines are a way for a homeowner to consolidate debt or pay for a home improvement project. And the interest is tax-deductible on a loan balance of up to $100,000.

Enticing as the idea might sound, dipping into your home’s equity for cash is risky business, especially if you don’t change the spending habits that put you in the financial tight spot. Taking out a home equity loan or line of credit isn't free money, and the risk is huge: You could lose your house.

It wasn’t so long ago that millions of Americans lost their homes, in part because they owed considerably more money than the homes were worth. During the recession, Americans shied away from home equity loans and lines of credit known as HELOC, because there was little equity left to tap and banks were reluctant to lend.

But now that home values are ticking up again, homeowners are once again looking to their house as a source of found money. The number of new HELOC’s rose 6.3% in 2012 compared to 2011. And the amount homeowners borrowed increased, too, by 11.2%. Today, Americans owe $78.2 billion in HELOC debt.

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Why Would You Take Out a Home Equity Loan?

The conditions are certainly ripe for a homeowner to consider a home equity loan or line. Interest rates are low and housing prices are rising, meaning there is more equity available in a home and debt is (relatively) cheap.

“As housing prices start to increase again, people naturally start to view the equity in their home as a tangible asset,” says Ellen Derrick, a certified financial planner™ with LearnVest Planning Services. “If they fail to realize that it is not the same thing as having cash in the bank, they could get themselves in trouble again.”

A homeowner can tap up to 80% of the home’s value, minus the balance of the mortgage. So, if your home is worth $500,000 and you owe $250,000 on the mortgage, you could take out a $150,000 loan at a reasonably low interest rate.

A home equity loan works much like a traditional mortgage with an appraisal and closing costs. A bank cuts you a check for a set amount of cash, with set payments of interest and principal paid over a period of time, such as 15 years. The money could be used for anything from remodeling the bathroom to paying off other debts. The interest is generally higher than a first mortgage because it is considered a second lien, but not as high as a credit card, and the closing costs are lower than a traditional mortgage.

How a Home Equity Line of Credit Works

A HELOC, on the other hand, works more like a credit card. A homeowner is approved for a line of credit and then can tap that credit at any time he wishes over a set period of time, such as 10 years. Some HELOCs have minimal closing costs. Unlike a loan, the interest rate is variable, but still lower than a credit card.

HELOC’s vary in how they are paid off. Some require a mix of principal and interest payments. Some require the borrower pay interest only for a set period of time, and then payments accelerate to a mix of principal and interest. Others have balloon payments where the line of credit matures and the entire balance is due all at once. In fact, almost 60% of all home equity lines will start requiring borrowers to pay the principal within the next four years, which could spell trouble for banks if borrowers can’t make the payments.

A maturing credit line can catch a homeowner off-guard if he hasn’t budgeted for the looming bill. If the home isn’t worth as much as the debt when the payment comes due, he has few options. He can’t sell the house to pay off the debt, and he can’t borrow anymore.

“Remember, the equity in your home is the difference between what you owe and what the market says your home is worth—and that is a moving target that is solely based on what someone else is willing to pay,” says Derrick. In other words, even if the value of your home decreases, what you owe on your loan won't change. And failure to pay could mean you go into foreclosure, even if you've always paid your mortgage on time.

The Risks and Benefits In Real Life

The risks notwithstanding, HELOCs can offer ways for a homeowner to float expenses they couldn't otherwise afford. Consider Sue James, a 63-year-old writer in Allentown, New Jersey. Three weeks ago she made the final payment on a $150,000 HELOC she opened 15 years ago, in 1998. Over the years she used the low-interest credit to pay for a new rec room in her craftsman-style house, a new car for the family, and to pay off her daughter’s student loans and part of her daughter’s wedding.

“It gave us the flexibility to have the things that were just slightly out of reach," says James.

And that's the double-edged sword of a second mortgage: While it may allow you to live larger, you're still living on borrowed money that will eventually need to be paid back.

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Although James never reached the credit limit, the balance on her HELOC soared above $90,000. Then, in the early 2000s, James’ husband received an unexpected inheritance, which the couple used to cut their debt down to $20,000.

Had they not received the inheritance, James doubts she ever would have paid the debt down. Now, rather than cut a check to the bank each month for her HELOC payment, she’s putting the money into her retirement account.

"If you're like most of us and aren't counting on wealthy relatives to leave you money, then you need to consider the debt in the same way as any other debts, including car loans, student loans, and credit card bills," says Derrick.

Before you take out any form of home equity loan, she says, there are three things you need to do: "Make sure you're addressing how to pay down those debts in addition to saving for retirement and other goals, because otherwise you may find yourself in a hole so deep that you can't dig out down the road," she advises. Also, consider whether you have the appropriate amount of money saved for emergencies. "Remember that equity isn't the same thing as cash, so don't count on that line of credit as your emergency fund," she says. "Ever."

RELATED: 7 Reasons You Need an Emergency Fund

Information shown is for illustrative purposes only and is not intended as investment advice. Please consult a financial advisor for advice specific to your financial situation.

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