If tuition fees or the family-room renovation have you looking for some extra cash, you may be considering borrowing against what is probably your most valuable asset: your home. But as always—and especially in light of the housing crisis and the current economic downturn—you should be aware of the risks and costs involved. Home-equity loans, also known as second mortgages, use the value of your property as collateral. Rates are generally lower than those for personal loans, and most interest payments are tax-deductible. We've laid out the basics so you can decide what's wise for your family.
What you gain
If your house is worth $500,000, for example, and you owe $200,000 on your mortgage, you have a $300,000 equity stake against which to borrow. In stronger economic times, you could borrow against 100 percent of this value, but currently lenders are being tighter with their loans.
What you risk
Since your home is your collateral, you could lose it if you are unable to repay the loan. And if your home decreases in value after you take out the loan, you could end up with "negative equity" (in other words, owing more in home loans than your house is actually worth).
What to do
You can get an estimate of your house's value on Realestate.com, but the only way to know the true value is to hire an appraiser. Before taking out a loan, comparison-shop, looking out for excessive fees and prepayment penalties. Don't be tempted to borrow more than you need.
What Your Options Are |
Close-Ended Loan
Open-Ended Loan
You borrow a lump sum, which you receive all at once.
What is it?
This is also known as a home-equity line of credit (HELOC): You get a set amount of money from which you can continuously borrow. After repaying the original loan, you can borrow it again (within a set period) without reapplying.
Tuition, consolidating debt, renovations.
What is it best for?
Home improvements, medical bills, emergencies.
A closed-end loan generally carries a fixed interest rate, so you know exactly what you'll owe each month, making this a less risky choice in a time of rising rates. For both types of loans, be sure to have a clear discussion with your bank about the various fees you'll incur, and ask whether there are ways to reduce them.
Keep in mind
Required minimum payments are often lower than those for closed loans, and rates are usually variable. Setting up a HELOC for a rainy day can be a good way to avoid credit-card debt in an emergency.
