Spring is the season when homeowners shake the money trees that they live in.
It's the time of year when people borrow against the equity in their homes: One-third of home equity lines of credit are opened from April through June as borrowers seek cash so they can fix up their houses.
But people don't spend their equity solely on home improvements. They use home equity loans and lines of credit to pay off credit card debt, to buy cars, to cover the kids' tuition and to pay for vacations. Now that the season for tapping equity is upon us, it's a good time to ask two questions: What are proper and improper uses for home equity debt? How much home equity debt is too much?
Three ways to tap equity
As a homeowner, you have three ways to tap your home's equity. First, you can sell your house, buy a cheaper one and pocket the difference. Second, you can refinance your mortgage, preferably at a lower rate, and borrow more than you currently owe and pocket the difference. As the refinancing boom winds down, that method is losing popularity.
The third way to extract equity is to get a home equity loan: a lump sum that you get when you take out a second mortgage. Nowadays, the most common way to turn equity into cash is take out an equity line of credit, which acts rather like a credit card. You withdraw money as you need it, and when you pay off the principal, the credit revolves and you can use it again.
"With home equity loans, you're placing your home on the line," says Rudy Cavazos, spokesman for Money Management International, a debt-counseling agency with offices in 10 states. "If you default on this loan, you could lose your house."
That's what you have to keep in mind. If you default on a loan backed by your house, you can lose the house, even if you declare bankruptcy. On the other hand, if you default on a credit card, you can have all or part of the debt forgiven in bankruptcy.
The interest on much home equity debt is deductible from federal income taxes, which makes it tempting to use equity to pay off credit card balances and car loans. As Cavazos notes, you have to remember that you are risking your house when you borrow against your equity in it.
Before you tap your equity ...
"There are a few questions people need to ask themselves, or a few steps they need to take, before jumping in," Cavazos says. The first is to evaluate all the options, including selling things you don't need and borrowing against one's 401(k).
Second, he says, shop around for an equity loan or line of credit. Compare interest rates, fees and rate caps. If you don't understand the words and phrases the lender uses -- such as APR, rate cap and variable rate -- ask for a definition or bring along a knowledgeable person.
Next, ask yourself what will happen if something bad happens.
"Come up with contingency plans and scenarios," Cavazos says. "How about if my spouse loses her job? What if we become ill for more than 30 or 45 days? Do we have short-term and long-term disability insurance? You've got to think of all these things."
Cavazos refuses to judge the wisdom of using equity to pay for things such as weddings and vacations. So does Jessica Cecere, president of Consumer Credit Counseling Service of Palm Beach County, Fla. People get into debt trouble because they borrow too much to pay back, not because they spend on the wrong things.
Cecere says it can be hazardous to pay off credit card debts with home equity debt because the temptation remains to charge up those cards again. You can end up much deeper in debt than you were before you got the equity loan. "That's when bankruptcy begins looking like an option," she says.
When people ask if they should tap their equity, Cecere answers that it depends on their self-discipline and financial savvy: "Does it make sense tax-wise? Or do you find yourself habitually in debt, and this is the way out?"
Beware high loan-to-value programs
Both Cavazos and Cecere are leery of equity lending programs that allow homeowners to borrow up to the value of their homes, or even up to 125 percent of the value of their homes. In the latter case, someone with a home worth $200,000 could have up to $250,000 in debt backed by the house.
"You really shouldn't be in a position where you could be upside-down on your house," Cecere says. "That's really scary."
Anthony Hsieh, president of HomeLoanCenter.com, an online lender that underwrites home equity loans and lines of credit, disagrees. Some borrowers are perfectly capable of borrowing up to or more than the value of their homes, he says. His bank approves high loan-to-value lines of credit only to people with excellent credit histories and sufficient income.
Hsieh believes that equity loans and lines of credit might actually keep some people out of bankruptcy. He says some homeowners get equity lines of credit while they have jobs, just so they will be able to tap those credit lines if they lose their jobs. After all, when you're unemployed, it's too late to apply for a loan.
"A lot of people are using lines of credit as a giant emergency credit card," Hsieh says, "accessing their home's equity until they can get back on their feet and catch up."