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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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