Be cautious with home equity debtSpring
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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