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Home Equity Protection - What's Best for You

by Broderick Perkins

Safe home equity use can stimulate your financial outlook.

However, excessive spending against the unencumbered value of your home could leave you in, well, financially transmitted distress.

"In a recent study released by the Massachusetts Institute of Technology and Harvard University, the shocking conclusion was that if it were not for the wide-spread and recklessly high number of cash-out refinances, the percentage of homeowners faced with negative equity in their homes would have leveled off at around 3 percent as opposed to the currently projected figures of 25 percent to 30 percent," said Nancy Osborne, chief operating officer of ERATE.com, a Santa Clara, CA-based financial information publisher and interest rate tracker. You don't have to abstain from spending against the equity in your home, as long as you guard against home equity excess.

Home equity is the difference between your mortgage balance and the value of your home.

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When you buy a home with a down payment of, say 20 percent, you have a 20 percent equity stake in your home. Over time, mortgage payments and appreciation can give you a larger equity stake. Likewise, depreciation can reduce your stake.

Lenders allow you to borrow money against some -- but rarely all of your home equity these days -- provided you qualify with good credit and adequate income.

Home equity can be an emergency fund, investment pot, nest egg for retirement or a way to get out of more expensive debt.

Just keep in mind, when you use it, you lose it.

"Home equity use has been the equivalent of home equity abuse over the past several decades," said Osborne.

A home equity loan, by it's very nature, is an equity-depleting loan. You don't have an unlimited amount of equity to bank on.

The most conservative financial planners advise not fooling around with your home's equity. Eventually pay off your mortgage so that when you retire on a fixed income you'll be home free with no mortgage payment.

However, emergencies do arise and it's nice to know you've got something to fall back on, other than credit cards.

That's particularly true as you age and your health wanes and during hard economic times that threaten your employment.

Again, the conservative advice suggests, instead of using your equity, even during an emergency, you should have socked away an emergency savings fund of from three to six months worth of your income as part of a sound financial plan.

However, even if you don't use your equity, it's not a bad idea to take out a home equity loan as a financial backup while you are fully employed. Once you are already unemployed or fully aware you will be laid off, it's probably too late.

If employment and income are necessary to qualify for the loan and you lie about your employment status, you are omitting a material fact and defrauding a lender. Lying on an loan application is a federal offense.

The best back up home equity loan is a home equity line of credit (HELOC). Like a credit card, if you don't use it, there are no payments, but it's there if you need it. HELOC's are almost always cheaper than a credit card, but it is a form of revolving credit, often with an adjustable interest rate.

A home equity loan for a fixed amount with a slightly higher fixed rate may be a good deal for set costs, financial endeavors, investments and the like. Because it is an installment loan with fixed payments, however, the loan forces you to begin making payments right away, even if you don't use the money right away.

Either loan could be a good choice for bill consolidation, but only if you have the will power to pay off bills and other credit that comes with higher interest rates and not use them again. The rates are lower than average credit card and retail store card rates.

Conservative and more liberal financial experts alike, say if you must use your home equity, the best use is to reinvest it.

The best investments include certain home improvements, education for the kids, new business finances, a second home and other financial moves that provide an equal or better return on your money than the cost of the loan.

Avoid buying big gas guzzling cars, boats, RVs, vacations, home theaters and other items that don't give you a return on your money.

"The incentives in the U.S. tax code which encourage this dangerous behavior must be debated and carefully re-evaluated," said Osborne.

Finally, don't overlook how economic conditions of the day can affect your home equity. This is especially noteworthy if you combine an adjustable rate mortgage (ARM) first with an adjustable rate home equity loan in a so-called "piggy-back" deal to finance most or all of the cost of a home.

With two mortgages, should interest rates rise and push up both monthly payments, you could quickly reach an affordability point of no return.

For example, in a soft housing market, with flat and falling home prices, there will be little if any home equity growth to bail you out, because your home could be worth less than the mortgages you seek to refinance.