Should you tap home equity?

NEW YORK (CNNMoney.com) -- Times may be getting tighter, but your bills and family plans can't be put on hold. That's why it may be all the more tempting to tap into what likely is your biggest asset: the house.

After all, you can get your hands on a big chunk of money to fund just about anything you need - home repair, tuition payments, a get-out-of-credit-card-debt-free card.

But even with reasonably low rates and potential tax deductions, you should know what you're getting into. Determining whether a home equity loan (HEL) or home equity line of credit (HELOC) makes sense for you depends on several variables. And before deciding, be clear on how the two instruments differ from each other.

A home-equity loan is essentially a second mortgage. You get a lump-sum of money and pay it back in fixed monthly installments over a fixed period of time, typically 10 years-to-15 years. The most common HEL has a fixed interest rate that you lock in when you secure the loan.

A home equity line of credit, by contrast, functions more like a credit card. You're assigned a credit limit and you pay back only what you use plus interest. When you secure a HELOC, you typically receive a checkbook or card which you may use up to your credit limit, typically in excess of $50,000. Whenever you use some of the credit, you'll owe a monthly minimum payment on your outstanding balance, but beyond that you determine how much you pay back and when.

The interest rate on a HELOC is pegged to the prime rate - the rate at which banks lend to their most creditworthy customers. The average HELOC rate is 1 percent over prime, although some HELOCs are set at prime.

When deciding whether to take out a home equity loan or line of credit, consider your goals, your payment schedule, your spending habits and your risk tolerance.

A home-equity loan is best used for a one-time goal for which payment will be due in full and which has long-lasting benefits. For instance, a loan makes sense if you want to fund a specific home improvement project that boosts the equity in your house or if you want to pay off high-interest credit card debt in one fell swoop.

What's more, a HEL makes sense if you like the security of a locked-in rate and knowing exactly how much you'll owe every month.

A HELOC, by contrast, gives you more repayment flexibility and lets you borrow only the amount you need when you need it. That way you're only paying interest on the amount you've taken, whereas with a loan, you pay interest on the money whether you're using it or not.

So if you're embarking on a multiyear home improvement project for which you'll have to write checks at varying times during that period, a HELOC might be best. (But carefully read the terms of your agreement. Some lenders may require you use a certain amount of credit by a given time, or that you withdraw a minimum every time you make a withdrawal.)

Also, since variable-rate HELOCs are tied to the prime rate, they can be more risky when rates are rising.

HELOCs are also good for short-term financing needs that arise unexpectedly, especially if you know you'll have the money in hand to cover an expense a few months after incurring it, perhaps through the sale of property or stocks.

A line of credit can be a smart choice for people who have already paid off their first mortgages and want ready access to cash if the need arises.

Similarly, you might consider taking out a HELOC just before retirement while you still have an income stream that qualifies you for one.

As attractive as a HEL or HELOC may be, ask yourself if you should be tapping into your home equity at all - keep in mind you put your home at risk of foreclosure if you can't make required payments. And consider whether there are less expensive ways to borrow money.

For instance, it may make more sense to do a cash-out refinancing, which increases your mortgage, potentially lowers your rate and pays you the difference between your old and new mortgage in a lump sum.

Second, if your reason for taking out a loan or line of credit is to help pay for years of living above your means and you haven't taken steps to rein in your spending, you shouldn't put your home at risk.

Lastly, if you're considering a HEL or HELOC for the tax break, think carefully. The interest deduction is not a dollar-for-dollar reduction of your taxes, just a percentage. Plus, if your adjusted gross income is high, the phase-out for itemized deductions may kick in, preventing you from taking a full deduction, if any at all.

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