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Dangers lurk in home equity

Home equity loans and lines of credit are some of the most popular home loans around, but dangers do exist.

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Here is how home equity borrowing works. You take out a loan against the equity in your house in one of two ways. You either obtain a straight loan that gives you a lump sum of money, or you have the money set aside as a reserve line of credit that you can tap into when you need it.

Let's assume you still owe $25,000 on your mortgage, and an appraisal shows the market value of the house is $125,000. Subtract what you owe from your home's market value, and the difference is $100,000. Since many banks will grant you a home equity loan or line of credit up to 80 percent of your equity, in this scenario, you can borrow up to $80,000.

This loan deal may sound great, but you shouldn't borrow that much when you have to make monthly payments on the $80,000 loan in addition to your regular mortgage payment. The two payments could strangle your wallet!

Plus, if you don't make the payments on time, it is foreclosure time and the bank owns the farm.

Lenders often use an introductory rate to lure you to home equity loans. The rate may last for six months to one year. But after the introductory period, the rate will jump to the bank's prime rate plus anywhere from 1 to 3 percentage points.

With a straight home equity loan, the rate is fixed from the start. You pay back the money in fixed monthly installments. By contrast, a home equity line of credit works like a revolving credit account, similar to credit cards.

The monthly payment on a line of credit is usually about 2 percent of the total outstanding principal amount of the loan. To use a simple example, if you borrow $10,000 at 10 percent, your first monthly payment is $200. Of that $200, $83.33 is interest and the remaining amount is used to reduce the loan amount. At the end of a year, you will have paid $938.26 in interest.

As with credit cards, interest can be added to your balance. Be careful as your interest rate adjusts that the monthly payment covers monthly interest payments or your balance will only go up.

Unless you're an ace at handling temptation, don't sign up for a home equity loan that comes with a credit card attached. The card lets you tap into your home equity as fast as you can pull out your wallet.

A home equity loan is a good choice for emergencies and for buying big-ticket items you could not ordinarily afford. It's also a great way to consolidate your bills at an interest rate substantially lower than the one banks charge for credit cards. However, it is important to be aware how the common---and expensive---pitfalls of a home equity loan can affect your wallet.

Bankrate.com's corrections policy
-- Posted: Nov. 1, 2005

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