Home Equity Basics

Homeowners are increasingly relying on their homes and rising property values to increase their purchasing power. Some are borrowing against the equity in their homes to pay down credit card debt and auto loans or even to finance vacations or renovations. These loans are more attractive than other forms of credit because, in many cases, the homeowner gains some tax breaks on interest. Additionally, because the loan is secured by their home, it will likely have a lower APR. However, home equity loans aren't right for everyone, so homeowners should carefully consider the pros and cons before signing on.

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There are two basic types of home equity loans: lump sum loans, which work like second mortgages, and home equity credit lines, which work more like credit cards. In both cases, the amount the homeowner can borrow is limited by their actual equity. Equity is calculated by subtracting the unpaid balance of the mortgage from the fair market value of the home.

Up-front home equity loans can cover big-ticket purchases

With an up-front home equity loan, or second mortgage, one can receive the full amount of the loan when it is opened, and pay it back in fixed monthly installments over the life of the loan. Up-front loans can be good for debt consolidation, buying a car, education, major home improvements, or paying large, unexpected bills, such as emergency medical expenses.

Home equity lines allow homeowners to borrow only what they need

More lenders are offering home equity lines of credit, which allow homeowners to draw off their loan as they need it, usually by writing a check. The monthly payment is usually a percentage of the total outstanding principle.

The particular benefit of home equity lines of credit, as opposed to up-front loans, is their flexibility. A credit line like this can be a good way to help pay for a child's education, for example, because one can borrow—and pay interest on—each year's costs only as they arise. With an up-front loan, one would pay interest on all the money from the very beginning.

Because this flexibility is the key benefit, be aware that some home equity lines specify a certain minimum be borrowed each time an amount is drawn, or that require an initial cash advance.

Examine all options before borrowing against the home

With interest rates that are typically lower than many credit cards, a home equity loan can be the one of the best ways to finance a large purchase or cover an unexpected expense. But home equity loans and credit lines are more expensive than first mortgages, and may be more expensive than other financing options, such as an auto loan or subsidized student loan. When considering a home equity loan, think through these issues:

Does this home equity loan offer the lowest interest available to finance this purchase?
Is the introductory rate much better than the long-term rate of the loan?
Will the interest be tax deductible? One way to be sure is by consulting a tax advisor.
Is the risk of putting the home on the line a worthwhile tradeoff to achieve this financial goal?

Finally, when considering an up-front loan or line of credit, ask a lender to help compare the interest rates. Matching up the Annual Percentage Rates alone may not provide an accurate picture, since the APR for a home equity line of credit is based on the periodic interest rate alone. It does not include points or other charges associated with an up-front loan.

A final caution
When borrowing against a home, a homeowner is securing the loan with collateral—their house. If one can't repay, the lender has the right to force foreclosure to receive repayment. That means the loss of the home and a foreclosure on the credit report. If a homeowner doesn’t think he or she may be able to make the payments when faced with a drop in income, then a home equity loan probably isn’t the right idea at this time. Additionally, if a homeowner is consolidating credit card debt, then it’s important to keep credit card spending under control.

Finally, if a home equity loan is a serious consideration, it's important to check interest rates and fees with a variety of lenders, and minimize inquiries on the report by only authorizing credit checks with lenders with whom they would like to do business.