Home Equity 101

Want to pay off high-interest debt in one fell swoop? Or, with the start of home improvement season, perhaps you're searching for ways to pay for a basement renovation, bathroom upgrade, or a new tile roof. Since you probably don't have that kind of money stuffed under your mattress, a natural place to look for more funds is in your single biggest asset: your home.

But before you tap into those funds, you need to know exactly what you're getting into. Putting your home at risk isn't for the uninformed or undisciplined.

Home equity loan vs. home equity line of credit

The first step to tapping into your home equity involves understanding your options. There are two major ones: a home equity loan (HEL) or a home equity line of credit (HELOC). Here's a handy guide to the basic differences between the two, including pros and cons.

Go straight to HEL
A home equity loan is, at heart, a second mortgage. You receive a lump sum at a fixed rate of interest that's locked in when you procure the loan. You're expected to pay it back in fixed monthly payments for a fixed amount of time (typically 10 to 15 years).

Pros:

• Your interest rate is fixed, which means no shocking increases later.
• Because payment is owed monthly, this can be a good option if you have a hard time exercising the discipline needed to pay off a loan a little at a time on your own.
• The interest rate on a HEL, though higher than that on your primary mortgage, will still be lower than the rates available on credit cards.
• If you're using your HEL to pay off credit cards, in addition to lower interest rates, you'll have the benefit of consolidating it all into one payment.
• The interest on your home equity loan may be tax-deductible, but you'll want to thoroughly read Publication #936 (the IRS's guidelines on the home mortgage interest deduction) to ensure the degree to which you're eligible. If your loan is for home improvement purposes (rather than, say, college tuition) you're allowed even greater leeway in deducting the interest.

Cons:

• You borrow (and owe interest on) the whole amount, rather than being able to simply borrow what you need.
• If you're using the equity to fund something that will involve multiple payments over time (say, for example, a phased home improvement project or quarterly payments on college tuition), you'll have to be sure not to spend the money on other things in the interim.
• If you use your HEL to fund something that immediately depreciates -- a car or new furniture -- you may hurt your net worth long-term. Boosting the value of your home has a better chance of enhancing your overall financial picture over the long haul.
• You may be prohibited from renting out your home, according to your loan terms.
• You risk losing your home if you can't make the payments.

How about a HELOC?
A home equity line of credit, by contrast, functions more like a credit card, only it uses your home as collateral. You ask for a line of credit, and the lender assigns a maximum amount you can borrow (a credit limit). Lenders typically determine this amount by taking a percentage of your home's appraised value and subtracting the amount you still owe on the mortgage; then they factor in things such as your credit history, debt load, and income. The lender then gives you a set of blank checks or a credit card that you can use to withdraw funds.

Unlike a HEL, the line of credit allows you to borrow what you need, when you need it, up to the full amount approved. So why wouldn't everyone want to apply for a HELOC in case an emergency strikes? Take a look at the pros and cons to see for yourself.