| Spring is the season
when homeowners shake the money trees that they live in.
It's
the time of year when people borrow against the equity in their homes: One-third
of home equity lines of credit are opened from April through June as borrowers
seek cash so they can fix up their houses.
But people don't spend their
equity solely on home improvements. They use home equity loans and lines of credit
to pay off credit card debt, to buy cars, to cover the kids' tuition and to pay
for vacations. Now that the season for tapping equity is upon us, it's a good
time to ask two questions: What are proper and improper uses for home equity debt?
How much home equity debt is too much?
Four ways to tap equity
As
a homeowner, you have four ways to tap your home's equity. First, you can sell
your house, buy a cheaper one and pocket the difference. Second, you can refinance
your mortgage, preferably at a lower rate, and borrow more than you currently
owe and pocket the difference. As the refinancing boom winds down, that method
is losing popularity.
The third way to extract equity is to get a home
equity loan: a lump sum that you get when you take out a second mortgage. Nowadays,
the most common way to turn equity into cash is take out an equity line of credit,
which acts rather like a credit card. You withdraw money as you need it, and when
you pay off the principal, the credit revolves and you can use it again.
With home equity loans, you're placing your home on the line," says
Rudy Cavazos, spokesman for Money Management International, a debt-counseling
agency with offices in 10 states. "If you default on this loan, you could
lose your house."
That's what you have to keep in mind. If you default
on a loan backed by your house, you can lose the house, even if you declare bankruptcy.
On the other hand, if you default on a credit card, you can have all or part of
the debt forgiven in bankruptcy.
The interest on much home equity debt
is deductible from federal income taxes, which makes it tempting to use equity
to pay off credit card balances and car loans. As Cavazos notes, you have to remember
that you are risking your house when you borrow against your equity in it.
Before you tap your equity ...
"There are a few questions people
need to ask themselves, or a few steps they need to take, before jumping in,"
Cavazos says. The first is to evaluate all the options, including selling things
you don't need and borrowing against one's 401(k).
Second, he says, shop
around for an equity loan or line of credit. Compare interest rates, fees and
rate caps. If you don't understand the words and phrases the lender uses -- such
as APR, rate cap and variable rate -- ask for a definition or bring along a knowledgeable
person.
Next, ask yourself what will happen if something bad happens.
"Come up with contingency plans and scenarios," Cavazos says.
"How about if my spouse loses her job? What if we become ill for more than
30 or 45 days? Do we have short-term and long-term disability insurance? You've
got to think of all these things."
Cavazos refuses to judge the
wisdom of using equity to pay for things such as weddings and vacations. So does
Jessica Cecere, president of Consumer Credit Counseling Service of Palm Beach
County, Fla. People get into debt trouble because they borrow too much to pay
back, not because they spend on the wrong things.
Cecere says it can
be hazardous to pay off credit card debts with home equity debt because the temptation
remains to charge up those cards again. You can end up much deeper in debt than
you were before you got the equity loan. "That's when bankruptcy begins looking
like an option," she says.
When people ask if they should tap their
equity, Cecere answers that it depends on their self-discipline and financial
savvy: "Does it make sense tax-wise? Or do you find yourself habitually in
debt, and this is the way out?"
Article continued at: http://www.bankrate.com/brm/news/loan/20030424a1.asp?page=default
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