Home Equity Guide

1. What's Home Equity?

At some point, you might find yourself looking for a slug of money that you don't have close at hand. It could be for home improvement project or something unexpected, like springing your brother from the slammer. Either way, you need money. What do you do if you don't have it in your checking account?

Well, if you own your home, you have the option of getting a home equity loan or a home equity line of credit.

A home equity loan is basically a second loan (after your mortgage) that you take out on your house. But where the first loan (your mortgage) went toward the purchase of your home, the second loan (the home equity loan) is just a lump of cash the bank hands over directly to you - to spend as you please. Pay for your kids' education, living expenses if you lose your job… or a lawyer for your brother.

Once you're approved for a home equity loan, you get a check for the total loan amount. Home equity loans have a fixed interest rate and a fixed term (the amount of time you have to repay the loan), usually 10 to 15 years. Then you'll make monthly payments on the loan until it's all paid up.

With a home equity line of credit (HELOC), you're approved for a total loan amount, but it's not given to you in one lump sum. You get a credit/debit card, or a checkbook (or both) and you withdraw money when needed. You only pay interest on the amount you have out, and you're only limited by the total amount of the loan. Up to $100,000 of the loan is tax deductible.

HELOCs are trickier than typical home loans that pay you one lump sum up front. They can have:

• Fluctuating Interest Rates - your payments can increase (sometimes drastically: some lenders offer a ridiculously low "introductory rate," only to jack it to the high heavens after a month or two).

• Advance Period Terms - only let you access the money for a set period of time, say five years. After then, you can't withdraw money and you have to repay whatever you borrowed over the next ten years (known as the "repayment period").

• Balloon Payment Terms - Some only charge you interest for ten years, but then want the whole loan paid off at once.

2. Should You Use Home Equity?

So should you look for a traditional home-equity loan (that pays you right away) or a home-equity line of credit (that extends a line of credit)?

Well, if you have a single, discrete expense (like a kitchen remodel), a regular home-equity loan is the right move.You get your money, you pay for your project and you start repaying the loan right away-in monthly payments that never change over the life of the loan.

But if you're looking at a series of payments over a period of time, or want a safety net that you can bail you out at a moment's notice, a HELOC is the better choice-you'll only pay for the money you need.

Most home-equity loans and HELOCs use the following formula to determine how much to lend:

75-80% of current home's value (determined by an appraiser's visit, which you pay for, and costs a couple of hundred dollars) minus the amount you owe on your mortgage. In the current market, where real estate values have declined, getting a HELOC has become tougher, but it's still an option for many homeowners.

Here's an example that assumes the bank will lend 75% of your home's value:

Current home value: $400,00075% of current value: $300,000

 Size of your mortgage: $250,000

 Amount lent to you: $50,000

Some lenders will lend you even more than 80% of the value of your home - up to 100% or even 125% of the home's value. But a home equity loan that large is risky, since your home might not appreciate that much by the time you're ready to sell. Indeed, home values haven't risen much at all of late. If the home value declines or doesn't rise much, you could get stuck owing money on your home equity loan, even after you sell the house. Here's how such a huge home equity loan can become a huge headache:

Current home value in 2008: $400,000125% of home value: $500,000

Size of your mortgage: $250,000

Amount lent to you: $250,000

Sale price of your home in 2011: $475,000

Mortgage in 2011: $240,000Total amount owed (mortgage and home loan): $490,000

In this example, the total amount you still owe the bank when you sell your home is $15,000 more than the price you get for your home. And that's not even including the closing fees, moving expenses, and other costs that come with selling your house! You are probably reading about a lot of people getting into trouble because they took out more money than their houses were worth, and then couldn't pay off the debt.

Again - approach these kinds of loans with care because you could end up owing more than the house is worth, especially if your home price declines or stays flat after you take out your HELOC.

3. Advice on Where and How to Get a Good Deal

Now that we've scared you enough with the risks involved in using home equity, we should tell you that there are some benefits.

A benefit of a home equity loans and HELOCs is that your credit score and credit history don't really have any effect on getting approved for the loan, or on the rates that you pay.That's because your home is the collateral. This may be good if your credit score isn't so hot, but keep in mind that, if you don't make payments, the lender can repossess your home. Also, just like a mortgage, up to $100,000 of the interest you pay on a home equity loan is tax deductible.

The process to get approved for a home equity loan or HELOC isn't nearly as big a hassle as getting a mortgage. Generally, all that's required to apply is an appraisal of your home and verification of your income. This also means that approval doesn't take as long. Usually, you can get a home equity loan or HELOC in a matter of weeks- it's much quicker than the months-long ordeal to get a mortgage.

But make sure you understand the fees involved. Of course, they're less than those for a mortgage. This makes sense, since the loan you're taking out is smaller. When it comes to fees and interest rates on these loans, you may want to shop around a little. Don't feel obligated to get your home equity loan or line of credit from the same lender as your mortgage - the two aren't connected in any way. But do check with your mortgage lender - they may be more likely to cut you a deal, since you're already a customer.

Also, read all the fine print on a HELOC. Some lenders require you to withdraw money-whether you want to or not-several times a year; they may also exact a heavy penalty (measured in thousands of dollars) if you decide you don't want the loan anymore, pay it back entirely and close the line of credit (this is called a "prepayment penalty"). Not all loans have these conditions, so if you're thinking of getting a HELOC but have no real intention to use it, make sure you can leave it alone without it costing you anything extra.

One last tip: go to a credit union. Credit unions often offer better home equity rates than other banks and lenders. If the credit union doesn't work for you, shop around your local banks as well as online lending sites like Lending Tree and E*Loan.

4. Grilling Guide: Questions to Ask When Shopping for Home Equity

Luckily, with traditional home equity loans, the process is pretty simple: you find a good rate for a term that works for you, and you apply. If you get the loan, congrats. You have the lump sum you need. But just in case, here are some questions you should ask before agreeing to anything.

I know that my interest rate is the prime rate, plus some extra points (called the "margin"). What's the margin on this loan?
The standard range is 2% to 3%.

What fees are involved in taking out this loan? Which fees are upfront, which go to you, and which go to any third parties?
Ask this question, in part, because it will show your lender that you mean business. Another reason to ask this question is that, well, lenders will probably try to rip you off by piling on extra fees. Don't let them get away with it. Make the lender explain each fee to you and, if something looks odd or excessive, don't be afraid to challenge them on it.

How long is your approval process?
Find out how long it usually takes for them to approve the loan process.

HELOCs are more complicated-here are some questions you should ask before agreeing to anything.

Does this line of credit have advance and repayment periods? If so, what are they?
Ideally, it doesn't. Unless you're being offered a killer rate and the advance period is in sync with your credit needs, we'd steer clear of loans that had this feature.

Is the rate you're quoting me an introductory rate? If it is, how long is the intro period and what does the rate go to afterwards?
The intro rate is just to get you through the door. Focus on the subsequent rate after the intro period expires. This is the number you're going to have to live with.

I know that my interest rate is the prime rate plus some extra points (called the "margin"). What will my margin be for this line of credit?
The standard range is two to three percent.

What fees are involved in taking out this line of credit? Which are upfront, which go to you and which go to any third parties?
This question is here, in part, to show your lender that you mean business. The other reason it's here is because lenders will, with a fair degree of certainty, try to screw you with extra fees. Make them explain each one and, if something looks odd or too much, challenge them on it.

Many HELOC lenders have no additional application fees when you sign up for a line of credit.

Does this loan have any minimum withdrawal or balance requirements, or any prepayment penalties or early-cancellation fees?
Again, it shouldn't.