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Home Equity Loans and Lines of Credit

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A home-equity loan is a loan that's taken against the equity you've built up on your home.

Again, this information might be a little premature if you haven't been in your house very long. But there's another neat tax advantage that comes with home ownership, and it's called a home-equity loan. If you get one of these handy little (or big) loans, you're allowed to write off 100 percent of the interest charges up to $100,000.

Home-equity loans and home-equity lines of credit can be very convenient. In fact, they can be lifesavers if you have unexpected expenses or expenses you just can't cover. These types of loans are taken, as the name implies, against the equity you've built up in your home. Your equity is used as collateral on the loan. Always remember, though, that there's a big risk associated with home-equity loans. If you default on the loan, you lose your home.

There are several types of home-equity loans. The first type is a line of credit. This means you're given approval from the lender to borrow up to a specified amount of money against the equity in your home. You don't get the money in a lump sum, but it's there for you to borrow, if you need it. This kind of loan can be extremely useful in the event of an emergency or unexpected expense. You don't have to pay interest on the money until you use it, so if you don't use it, it costs you nothing. The interest rate on this type of loan is variable—that is, it fluctuates with the current interest rates.

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Prime rate is the interest rate that banks charge their most creditworthy customers. All other borrowers are typically charged at some rate above prime, depending on their risk.

Because current interest rates are low, these loans are popular. The problem, though, is that the rates will increase as the prime rate—a sort of starting point for banks—increases. The higher that interest rates are in general, the higher the rate your loan will be charged. If you borrow using a line of credit, be certain you can afford to pay higher payments in case the interest rates increase significantly.

The other kind of home-equity loan is a fixed-rate loan. Your equity is calculated, and you borrow money against it. You repay the loan on a fixed schedule at a fixed rate of interest. You can always pay more on the loan than is required, but don't pay less than the fully required amount. This is a loan, not a line of credit.

There usually aren't as many fees associated with home-equity loans or line-of-credit loans as there are with a mortgage, but be assured, there are some. You'll probably have to pay a mortgage application fee, an appraisal fee, a fee for a credit report, and possibly processing fees. You won't have to pay points, however. If you're in line fora home-equity loan, go to the first meeting prepared, as you would be if you were applying for a mortgage. The application and processing time will be shortened considerably if you're well prepared.

Money Pit

Lenders have been getting fee-happy lately when it comes to home-equity loans. If your lender tries to tell you that you have to pay points, however, tell him to take a hike, and go elsewhere.

Home-equity loans make sense in many cases. For instance, if you want to borrow $20,000 for a new Honda, you can take a car loan. Back in the good old days (before the tax law revamping in 1986), you could have even deducted your car loan interest. Not now. If you get a home-equity loan, however, and use it to pay for the car, you can deduct the interest and save yourself some money. But we can't stress how important it is to understand the risks of home-equity loans.

Especially with a home-equity line of credit, use caution. It's like having a huge credit card to use whenever you want. The problem is, if you don't control the spending, it's your house that's on the line.

More on: Family Finances

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Excerpted from The Complete Idiot's Guide to Personal Finance in your 20s and 30s © 2005 by Susan Shelly and Sarah Young Fisher. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

To order this book visit the Idiot's Guide web site or call 1-800-253-6476.


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