Capital sources: Home equity loans

Real property also can be used as loan collateral, either through a home equity loan or an open line of credit. A home equity loan will provide a lump sum of cash, with terms similar to a first mortgage. This type of loan requires you to pay up front points and fees.

A home equity line of credit (HELOC) is a cross between a second mortgage and a credit card. You borrow against the built-up value in your home -- above what you owe on your first mortgage. You draw on the money when you need it and repay it in the same fashion as you would pay a credit card balance.

Most home equity loans are considered second mortgages, whether you get a lump sum or a line of credit. The interest rates are generally lower than other secured loans, currently in the mid-7 percent to low-8 percent range. Also, the interest on some mortgage loans is tax deductible, and that is not the case with any other consumer loan.

How large a loan can you obtain?
Home equity lines resemble any other loan where property is put up as collateral in that the amount you can borrow is based on a loan-to-value ratio. Typically, residential real estate has an 80 percent loan-to-value ratio, while commercial property has a 60 percent loan-to-value.

Example: You have a home appraised at $300,000. An 80 percent loan-to-value means that the bank could loan you up to $240,000. But let's say you hold a first mortgage of $200,000. The bank will only provide a home equity line for the difference, or $40,000.

Remember, you have to make monthly payments on the new loan in addition to your regular mortgage payment, which means your debt-to-income ratio is getting higher. If you don't make the payments on time, the bank will foreclose on your home.

What you'll pay: If you took out a home equity loan of $40,000 for five years at 8 percent interest, your 60 monthly payments would be $811. During the five years, $8,663 in interest would accrue. If you use Schedule A to itemize deductions on your tax return, you could quality for federal tax savings on the interest. If your tax bracket was 28 percent, you could save $2,426 in taxes.

Banks like home equity lines because they're secured by real property, not a promise to pay. Looking for a home equity loan or line of credit? Here are some questions to ask:

• What's the fully indexed rate on the equity line, not the starting rate? The rate should be tied to prime and no more than 2 points above that. Ideally, you would find a prime-for-life deal.
• What's the highest the rate can ever be? The lower, the better, naturally. Ask if the rate cap can be adjusted under certain circumstances.
• What closing costs must I pay, and how much do you expect that they will be? Look for a no-closing-costs deal, but weigh that against an equity line with lower rates and rate caps.
• Are there any account fees? Some institutions levy an annual fee, and some have a fee if you do not use the account. These charges can add up.
• What are the repayment terms? Reliance, for example, lets customers pay interest only for the first 10 years, and then amortize the balance over the following 20 years. That's very expensive; look for repayment schedules which pay down the balance every month.