How To Use Your Home Equity Wisely

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Americans saw the value of their houses jump an average of 13 percent over the past year, according to the Office of Federal Housing Enterprise Oversight. This has made it easier than ever for many houseowners to qualify for a house equity loan or line of credit.
With their low interest rates, these secured forms of credit can be your most effective way to borrow money. Plus, loans of up to $100,000 often offer the additional benefit of being tax deductible (check with your tax advisor). But it's important to choose the right house equity loan for your needs and to use it wisely.

Smart Borrowing

Financing a renovation that will add value to your house, such as a new kitchen or a second bathroom, or helping with your child's college tuition, are valid reasons to borrow on the strength of your house equity. This is especially true since the borrowing costs are generally much less expensive than debt that is not secured by collateral.

By the same token, shifting hefty balances you owe on credit cards to a house equity loan can be a good move. Your credit cards are likely charging annual interest of 13 percent or more, so consolidating that debt with a house equity loan can easily slash your borrowing costs in half.

Remember though, the idea is to eliminate your debt, not make room for more of it.

A house equity loan isn't free money. At the end of the day, your house is what's backing the loan. So if you miss payments, the lender could take possession of your house.

There are also important differences between a house equity line of credit and a house equity loan -- differences that can help you determine which is a better choice for you.

Home Equity Line of Credit

A house equity line of credit (HELOC) allows you to use as much or as little of your pre-approved limit as you like. Plus, you are charged interest only on the portion of credit you are currently using, which keeps borrowing costs low. The rate of interest floats slightly above the prime rate.

This flexibility is helpful if you're looking to do a series of small house renovations over a long period of time, or perhaps finance the start-up of a house-based business.

* The advantage: If the prime rate decreases, your cost of borrowing will become cheaper, and interest rates are still very low compared to previous decades.
* The disadvantage: If the prime rate increases, your borrowing costs will increase as well. If you find it difficult to squeeze in credit-line repayments now, you may risk missing some repayments altogether when interest rates go up.

Also, depending on the terms of your particular HELOC, you may be required to pay only the interest accrued each month. On the upside, this means your minimum payments will be low during the interest-only period. On the downside, you will not be rebuilding any of that valuable house equity you've just borrowed against.

When the interest-only period ends, you will be faced with one of two scenarios. You may be required to begin paying back the loan principal (the original amount you borrowed). That means your monthly payments will increase, and if you don't have enough money coming in to cover those larger payments, you could be in trouble. Or you may be facing what's called a balloon payment, meaning you must pay the entire outstanding balance of your HELOC in full.

Always try to pay more than the minimum each month, so you are constantly chipping away at your loan principal.

Home Equity Loan

A house equity loan has a fixed interest rate. You receive the full amount of the loan in a lump sum, which makes it a good choice for large, one-shot expenses, such as a house renovation or debt consolidation. And therefore you must pay it back in regular increments over a specified period of time -- often 10 to 15 years -- a house equity loan offers a measure of built-in discipline for those who may be tempted to use the "interest-only" payment option offered by some HELOCs.

At the end of the repayment schedule, a house equity loan will be repaid in full.

Loan-to-value ratio The general rule is you can borrow 75 to 80 percent of your house's current appraised value, minus what you owe on your first mortgage. This is called the loan-to-value ratio (LTV). For example, if your house is worth $200,000 and you owe $100,000 on your current mortgage, you could borrow an additional $60,000 and still be within an LTV of 80 percent. Staying within the sensible 75 to 80 percent range will help you avoid repayment problems down the road. However, some lenders have begun to offer a "high-LTV" option in which you can borrow up to 125 percent of your house's equity. Beware: If you decide to move therefore of a job transfer or other reasons, the sale of your house may not provide you with enough money to pay off both your mortgage and the outstanding house equity loan.

Borrowing conservatively is always wise.

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