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By
Hark The Herald
If you have equity in your home and need cash
to pay off high-interest credit cards or cover an emergency, then
refinancing or getting a second mortgage to tap that equity might
seem like a cheap, safe way out of debt. After all, you'll pay less
interest on a mortgage or equity loan than on other types of loans,
and that interest probably will be tax deductible. Sounds like a
good thing, right? Yes and no.
Remember that taking money out of your house
is not the same as withdrawing cash from your savings account or
redeeming a certificate of deposit. Unlike deposit investments --
which you own and which pay you interest income -- home loans that
tap your house's equity are just that: loans. You'll still owe principal
and interest to a lender; you've simply shifted the debt to a different
lender at a different rate.
There's only one way to get the equity out of
your humble abode without having to repay it -- sell the house.
Let's say you sell your home for $150,000, and you owe the mortgage
company $100,000. You've accomplished three things: you've raised
$100,000 to pay off the lender, you've freed up $50,000 in cash
equity, and you've left yourself homeless.
Now let's say you have $50,000 of available equity
in your home and you either refinance or take out a second mortgage,
such as a home equity loan or a home equity line of credit, more
commonly known as a HELOC. You still have a place to live and you
get your $50,000 in cash, but now you also owe $50,000 plus interest
to the mortgage lender.
Freeing the equity trapped in your home to bankroll
other uses makes economic sense under certain circumstances, says
Catherine Williams, vice president for education for Money Management
International, a nonprofit credit-counseling service in Chicago.
“It makes sense to tap it once and once only to pay off credit-card
or other high-interest debt,” Williams says. However, she
advises people to think about what they are really doing, and about
how much that low-interest loan will cost them over time. “The
thing I point out is that you are moving unsecured debts to secured
debt. You are using up the equity in your home to pay for your old
tennis shoes and your sister-in-law's shower gift.”
If you do have equity in your house, there is
a strong temptation to use it. Many lenders urge you to take out
bill-consolidation loans or put your “unused equity”
to work for you. If you live in one of the country's “hot”
real estate markets where housing prices are soaring, you may have
more equity in your home than you realize. The problem, Williams
points out, is that hot markets eventually turn cold. There is no
guarantee your home will continue to climb in value at the same
"hot-market" rate or that it even will keep its current
market worth.
In a nation where the savings rate is less than
1.0 percent, millions of people find their homes and the equity
in them are the only savings accounts they have. Many people look
at their homes a source of retirement income down the road and as
a safety net right now.
The problem is that "safety net" means
different things to different people, especially as market conditions
change. “When home prices started climbing and interest rates
began to drop, we actually saw a decrease in the number of people
coming into debt management programs because they had a simpler
tool to pay their debts," Williams says. "They tapped
into their home equity and paid off their debts. Now we're seeing
repeat 'tappers.' They tapped once to pay off their credit-card
debt, but they didn't learn anything. They kept spending and running
up their credit-card debt.”
Many people, hoping that home appreciation will
keep up with their spending, run up another $10,000 or more in new
credit card debt while they are still paying off their first home
equity loan. “If you had a home equity loan and then paid
it back, then you are in good enough shape to hit it again,"
she adds. "It's when you take out another loan and add that
debt to an existing home equity loan that you get into trouble.”
You also might be on the road to paying even more money in long-term
mortgage interest than you would have on shorter-term credit-card
debt. “If you took $15,000 in debt and converted it from an
evil 18- or 20-something-percent credit card interest to a 5-percent
home-equity interest, and then spread that debt out over 15 or 20
or 30 years, you would wind up paying more than if you had paid
it off as credit card debt," Williams says.
“Home equity is supposed to be used when
you sell the house so you can make a larger down payment on the
next one,” she adds. “Or you use it for home improvements,
or you use it once to get out of credit card debt. In some cases
you use it to help you take care of aging parents, or maybe for
your own retirement.” Home equity is “a form of forced
savings,” she says, and that is a good thing.
At some point, all homes will be sold. “What counts is how
much you get to keep, not how much you have to pay off. By tapping
into your home equity, what you are actually doing is decreasing
your own wealth.” And while it does make sense in some cases,
running up more credit card debt while you are still paying off
a second mortgage isn't one of them.
Used wisely, loans against home equity can be
a boon to cash-strapped homeowners. Spent indiscriminately, these
same loans can cost you your home and financial security.
Before you buy real estate, educate yourself about what's involved.
Real estate guides are an excellent place to start.
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