Tuesday, September 4, 2012

Home equity loans and lines of credit: Consider the pros & cons

 

It's a simple calculation. Deduct the outstanding balance on your mortgage from your home's market value. The difference is home equity. For example, if your house is worth $300,000 and your outstanding mortgage (including any other liens tied to the property) is $200,000, your home equity is $100,000. And as lenders are quick to point out, that equity represents a ready source of cash. It can be used to pay for emergencies, home improvement projects, debt consolidation, tuition payments, even a cruise in the Bahamas.

The two main vehicles for tapping your home's equity are home equity loans (HELs) and home equity lines of credits (HELOCs). With a HEL, you get the loan proceeds in a lump sum and establish payment terms (loan amount, payoff period, and interest rate). In that sense, a HEL is similar to an automobile or consumer loan. A HELOC, on the other hand, acts more like a credit card. The lender establishes a limit against which you may borrow, and the interest rate tends to be variable.
Before using the equity in your home to bolster your bank account or pay off high-interest debt, consider the following:

  • A home equity loan is best used for a one-time goal, such as remodeling a kitchen. Using the proceeds for a project that increases the home's value may even pay for itself in the long run. A home equity loan provides the security of a fixed monthly payment, a stable interest rate, and a definite term (typically ten to fifteen years), making it a good choice for planning purposes. On the other hand, if your income suddenly dries up or your home's market value drops, you're still on the hook to make those payments.
  • Home equity lines of credit provide more flexibility, making them useful for, say, a remodeling project to be completed over an extended period of time. You take on only as much debt as needed to complete the next step in the process. On the other hand, a line of credit's variable interest rate makes it more risky when rates are climbing. And like a credit card account, a line of credit is easy to abuse.
The decision to tap your home's equity using either of these vehicles will depend, to some extent, on your tolerance for risk. Remember, if you fail to make the required payments, your house is on the line.

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