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Time to tap home equity?
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November 8, 2001: 6:30 a.m. ET
Home equity loans and lines of credit now cost less. Are they right for you?
By Jeanne Sahadi
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NEW YORK (CNNmoney) - 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.
In the midst of 10 interest rate cuts by the Federal Reserve this year, the cost of borrowing money against the equity in your home has gotten considerably cheaper. And, unlike other forms of consumer debt, the interest you pay may be tax-deductible.
But even with 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.
Mortgage vs. credit card
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, like a mortgage, 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 credit card which you may use up to your credit limit - the average is $58,800, according to the Consumer Bankers Association (CBA). 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, said CBA spokesman Fritz Elmendorf.
So which is better?
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, said certified financial planner Jon Duncan of Tacoma, Wash., 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, Elmendorf said.
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 HOW MUCH HAVE HOMEOWNERS BORROWED?
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Source: Consumer Bankers Association
Avg. home-equity loan: $33,000
Avg. home-equity line of credit: $58,800
Avg. outstanding balance on HELOC: $28,500
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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, for instance, 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, said Elmendorf, since variable-rate HELOCs are tied to the prime rate, "HELOCs are more risky in an increasing-rate environment." Currently, HELOC rates are at historic lows, with an average variable rate of 6.37 percent.
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. "It's a good liquidity fallback if you need cash in a hurry," Duncan said.
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, he added. Similarly, certified financial planner Barbara Steinmetz of Burlingame, Calif., recommends clients take out a HELOC just before they retire, when their income stream still qualifies them for one.
Some people suggest using a HELOC as a substitute emergency fund in the case of a potential layoff or other cash-critical situation, but Steinmetz only recommends it if the borrower is financially responsible and won't abuse access to the equity.
Should you tap your home equity?
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. Even though home equity loan rates have come down, they're not the cheapest money out there, said Keith Gumbinger, vice president of HSH Associates. Gumbinger notes that the 30-year fixed-rate mortgage has averaged between 6.5 percent and 6.7 percent in recent weeks, far below the 8.31 percent average on HELs. (See if your situation fits one of these five refinancing scenarios.)
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, Steinmetz said.
Lastly, if you're considering a HEL or HELOC for the tax break, think carefully, she said. The interest deduction is not a dollar-for-dollar reduction of your taxes, just a percentage; and with tax rates declining, the deduction may not be as valuable as you think. 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.
And there may be better deals out there even if you do get the deduction, Steinmetz added, citing as one example the recent 0-percent financing deals on some cars. In short, she said, "Don't let the tax tail wag the financial dog." 
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