Advantages and Pitfalls of Home Equity Borrowing

Scenarios when borrowing might make sense

You have erratic or hard-to-prove income: Because home equity borrowing is a secured loan and a number of lenders still base loan approval on credit score alone, you have a better chance of approval, providing your credit score is good. Plus a line of credit can act as backup between income infusions, usually at a lower rate than credit cards.

Your child is applying for financial aid at a private school: Need-based student aid decisions are determined partially on your assets, including primary residences whereas credit card debt is not reflected. Consolidating credit card or other outstanding debt using home equity dissipates the value of that asset, more accurately reflecting your financial picture. NOTE: This does not apply to FAFSA, the Free Application for Federal Student Aid, used at state schools.

You need to bridge a short financial gap: If you have a realistic view of your financial picture, and have determined you have the means and financial discipline to pay down the loan, there are benefits that could make home equity borrowing the smartest choice.

Advantages of home equity loans

Tax-deductible interest: Interest on the first $100,000 is tax-deductible, regardless of use. Additional interest may be tax-deductible if used for a business expense or another allowable purpose. Remember, you must itemize.

Lower rates than unsecured loans: Lenders carry lower risk holding your home as collateral, translating into lower interest rates than offered with unsecured loans.

Pitfalls of home equity loans

Not everyone can deduct interest: You must file an itemized tax return to claim the tax deduction on the interest paid. Your tax savings isn't dollar-for-dollar, says Katie Porter, associate professor of law at the University of Iowa and mortgage bankruptcy researcher. "For every dollar you get to deduct, you're reducing your income, which saves you -- depending on your tax bracket -- 20-25 percent on your taxes."

Shouldn't be used in place of making tough financial decisions: Taking on debt when money is tight is rarely a good idea. "It might be better to sell your car and get a cheaper one," Porter says, "than to put your house at risk."

You're taking on risk: "People need to be clear with themselves about the risks," says Porter. "Be very aware that your home and all the payments you have made toward it are the collateral. With unsecured credit, the interest rates are higher because it is the lender who is assuming the bulk of the risk. Securing your loan with your house as collateral means that you are assuming the bulk of the risk." You could lose your home.

It may limit your options: Your home's value may slide, leaving you owing more than you can get for your house if you try to sell. This is especially a problem for high loan-to-value (LTV) loans, in which the borrower can draw on up to 100 percent (and sometimes more) of the home's equity.

Understand the terms: Home equity lines of credit, or HELOCs, and many subprime loans often come with stiff prepayment penalties, sometimes equivalent to six months' payment. Adjustable-rate mortgages, or ARMs, frequently start off with a low teaser rate that increases after a set amount of time. Crunch the numbers on the ceiling amount; make sure you can afford your payments when the interest rises.

Plan for the unexpected: "Unexpected crises -- getting sick, getting hurt, losing a job, having spouse leave you -- almost all of us will experience this type of loss at one time or another and consumers need to build a cushion into their budget," says Porter. She further cautions, "If you tap into equity in good times, then you won't have money to tap in an emergency."

Don't ignore your other options

Lower interest rates can be enticing, but consumers should consider all other options before converting unsecured debt to a secured loan. Try these strategies.

Call credit card companies. See if you can work out a payment plan and negotiate lower rates.

Consider credit counseling. Choose a nonprofit credit counselor to negotiate on your behalf.

Cut back somewhere else. Get a cheaper car. Have a yard sale. Put your wallet on a diet.