As home values rise in many markets, Americans are increasingly tapping the equity in their houses to borrow money using either a home equity loan or a line of credit. The equity refers to the difference between what you owe on a house and its current market value. For instance, if you owe $100,000 on your mortgage but your home is worth $150,000, your equity is $50,000.
Why are home equity products so attractive? They offer homeowners great flexibility to finance major expenses, including home improvements and college tuition. They usually have a lower interest rate than credit cards, and the interest often is tax deductible (check with your tax advisor). But these loans also come with risks. The most important thing to remember is that your home is collateral for the loan. "That means if you run into repayment difficulties, you could lose your home," cautioned Richard Brown, the FDIC's Chief Economist.
So, before you put your home at risk, you should learn more about how these loans work and what can go wrong if they are not used carefully.
The "traditional" home equity loan (HEL) is a one-time loan for a lump sum, and typically at a fixed interest rate. The loan is repaid in equal monthly payments over a set period of time.
A home equity line of credit (HELOC) is very different because it works like a credit card. You receive a line of credit from which you can draw money. As you repay the principal, your available credit goes up again, just like a credit card. Typically, the interest rate on a line of credit is variable, meaning that it is tied to an index and will change with movements in interest rates.
With both types of home equity products not only could you lose your home if you can't repay the debt, but you also are at risk if there is a drop in the value of your home. Although the housing market has done extremely well in recent years, there is always a chance that real estate values will go down.
"Home equity borrowers need to be aware of the trend of home prices in their area," said Barbara Ryan, an Associate Director in the FDIC's research division. "If prices go down, you could owe more on your home than it is currently worth, which means you cannot sell the house without taking a loss."
HELOCs often come with extra-low interest rates for an introductory period, such as six months, but these are variable rates that could go up during the life of the loan. When deciding whether a line of credit is right for you, ask yourself if you can afford the increased monthly payments after the introductory period ends or when interest rates rise. You'll also have to decide if you are comfortable with a fluctuating monthly mortgage payment or whether a fixed interest rate and stable payments are better for you.
Also remember that you are drawing out the money you have invested in your home so you should think carefully about what you do with that money. "It's generally best to invest in another asset of long-term value, such as a home renovation or college tuition, instead of paying for a car or a vacation," added Brown. "The flexibility these loans give you can be dangerous because if you're not disciplined about how you use the funds, you could end up paying a lot of money over a long period of time for something you no longer own or that didn't add any value to your existing assets."
Fortunately, you have specific rights if you're using your home as security for a home equity loan or line of credit. Federal law gives you three business days after signing the loan papers to cancel the deal—for any reason—without penalty. You must cancel in writing. The lender also must return any fees or finance charges you had paid. This right doesn't apply if you are refinancing or consolidating existing loans without borrowing additional money.
