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Are Home Equity Loans and Home Equity Lines Of Credit A Good Idea?
When your debts have gotten way ahead of your ability to pay them off, tapping your burgeoning equity in your home seems like an easy (and compelling) solution.
But is it? Here’s one more area where you need good advice. This kind of loan is a fast and obvious way to get a large amount of cash at a relatively low cost. But be careful. Borrowing against your home means you could lose your home if you can’t repay the loan as promised.
The equity in your home is the difference between what you owe on your mortgage and the current market value of the home. For example, if you owe $150,000 on a home with a current market value of $250,000, your equity is $100,000. That means you could borrow $100,000 based on your equity. In fact, some lenders might even give you more. The thing to remember here is that you are borrowing, and you are going to have to pay it back-or sell your home if you can’t.
Using your equity is quick and easy. It can be done one of two ways, either as a home equity loan, which is like taking out a second mortgage, or as a home equity line of credit, which works more like a credit card with a fixed amount you can draw upon as needed. Both are attractive because interest rates are low, lower than the average credit card rate, and interest is tax deductible, just like the interest on your mortgage.
This is such a popular quick fix that you have to pay careful attention to the fine print. Even though in theory the money is yours-or would be if you sold your home-you do have to pay the loan back, with interest, or risk losing your home.
Lenders have devised a variety of options to make home equity loans and lines of credit attractive. An interest only loan, with the promise of a low rate and low monthly payments, is one popular offering. The catch is the “balloon” payment required to repay the entire amount at the end of the loan. This kind of loan only makes sense if you plan to sell your home before the loan matures. If you can’t make the final payment, you may be forced to sell anyway.
You also need to beware of the variable rate approach, especially if an artificially low rate was what attracted you in the first place. You need to understand how and when the rate will be adjusted so you won’t be surprised if your monthly payments increase suddenly. If interest rates are rising, you may want to consider a fixed rate instead of a variable rate. That way you can at least be sure of what your payments and commitments will be for the duration of the loan.
Other items to watch are the fees and charges, since you will probably be paying an application fee, the costs of an appraisal, various closing costs, possibly points and a maintenance and/or transaction fee. Some home equity lines of credit even impose an inactivity fee if you don’t use the credit. All of these can add to your costs, and payments.
You also need to recognize that by using the equity in your home you are taking away from what, for most people, is a major investment, their home, and exchanging long term debt, your mortgage, for short term debt, your overworked credit cards. Even if the value of your house declines, the amount you borrowed on your equity stays the same. Say the value of your $250,000 home declines to $200,000 and you had borrowed $100,000. Even if you sell the home, you will have to come up with another $50,000 to repay your loan.
An even bigger risk, say experienced financial counselors, is that with an easy source of cash, debtors may not learn a lesson and, failing to curb their spending, will get into the debt trap again-this time without a home equity loan to rescue them.
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