Should You Take Out a Home Equity Loan?

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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.