What you should know about home equity loans

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Despite their risks they are often better than other sources of credit

During the housing bubble millions of people borrowed against the equity in their homes and lived to regret it.

But home equity loans and home equity lines of credit (HELOC) remain legitimate and useful sources of credit as long as they are used properly. Since these loans are essentially second mortgages on your home, you should use great care in selecting and managing one of these loan products.

That starts with reading the credit agreement carefully and examining the terms and conditions of various plans, including the annual percentage rate (APR) and closing costs. It's not enough to just look at the interest rate.

Fixed rate or variable?

When comparing loan products, you'll find that different loans have different rate structures. Some have a fixed interest rate and some rates float, based on some benchmark like the prime rate.

The interest on variable rate loans has remained low over the last 6 years but that doesn't mean it will stay that way, especially if the Federal Reserve (Fed) begins raising rates later this year, as many market analysts expect.

According to the Fed, variable-rate plans secured by a home must, by law, have a cap on how much your interest rate may increase over the life of the plan. Some variable-rate plans limit how much your payment may increase and how low your interest rate may fall if the index drops.

Home equity loan

A home equity loan is similar to a mortgage in that you borrow a lump sum of money and begin paying it back over a fixed period of time – usually 15 years – at a fixed interest rate. It's a second monthly payment, on top of your principal mortgage payment.

A home equity loan is best used for a specific purpose, ideally to improve the value of the property. You might use the money, for example, to build an addition to your home.

Line of credit

A HELOC is a much more flexible loan and, because of that, requires a lot of self-discipline in how it is used. If a lender offers a $50,000 HELOC, for example, you do not have to draw any of the money until you need it – and even then you don't have to draw all $50,000.

In that way, it is a lot like a credit card – which is where the danger comes in. If the money is used to pay restaurant bills and to take vacations, you can run up large balances just like a credit card – but with much more dire consequences. Credit cards are unsecured; home equity loans and HELOCS are secured by your house. 

HELOCs can be structured in different ways. Some lenders off a 25-year term, with the borrower able to draw on the line for the first 10 years, then pay it back over the next 15. Some lines have no payback period at all, with the entire balance due at the end of a 10-year term.

This is where it is easy to get into trouble. Consumers need to have a plan for paying down the HELOC whenever they draw on it.

Short-term tool

A HELOC is best used as a short-term financial tool. If, for example, you have $8,000 in high interest credit card debt you are struggling to pay down, paying it off with a HELOC then allows you to use those monthly payments to pay down your line.

Because the interest rate is much lower, the debt will be repaid much faster than if you kept paying on the credit card with double-digit interest. Best of all, the interest on a HELOC is generally tax deductible (always check with your tax advisor first). Credit card interest is not.

Despite their risks, home equity loans and HELOCs are usually a safer and more cost effective financial tool than many other sources of credit. Your local bank probably offers one of these products.

The amount you can borrow will depend on normal credit considerations, along with the amount of equity you have in your home. Online calculators like this one can help you arrive at the potential amount you can borrow.

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