Do you dare tap your home equity?

Do you dare tap your home equity?. Despite the real-estate meltdown, millions of Americans still have substantial equity in their homes. The question is whether they should do anything with that wealth. You've heard by now that one-quarter of U.S. homeowners with a mortgage are "underwater" on their loans, owing more than their houses are worth.

That percentage is likely to grow. Deutsche Bank predicts nearly half of mortgaged homeowners, or 25 million households, will be underwater by the time the housing recession ends. That's grim, but the flip side is that most U.S. homeowners still have equity in their homes -- sometimes a lot of equity.

Twenty-three million households have 20% or more equity in their homes, according to First American CoreLogic; 24 million households own their houses free and clear.

The question now is what, if anything, they should do with that wealth. Here's the central problem:

• If they tap their equity and borrow too much, and if home prices fall further and they have to move, they could join the legions of underwater homeowners who faced ruined finances and trashed credit.
• If they don't borrow, the equity they could have turned into cash might instead disappear.

Regular readers won't be surprised to learn I'm urging caution.

If you're lucky enough to still have equity, your priority should be keeping your head above water, not trying to turn your home's value into cash.

That means capping your borrowing at 80% or less of the value of your home. Keeping at least a 20% equity pad has always been a good idea, and now it's enforced by lenders, who are reluctant to lend more. (The limit is lower in hard-hit areas such as Florida and Nevada, where 60% to 65% caps on borrowing are common.)

You'll want some breathing room in case prices fall more; people with equity have a much easier time if they have to sell.

Besides, much of the home equity borrowing that's occurred in the past decade has been a mistake. Too often homeowners squandered what should have been long-term wealth on short-term spending.

Here are some common ways people spend their home equity -- debt consolidation, remodeling, cars and college -- and what you should think about before you join them:

Remodeling your home

Remodeling is not, I repeat, not an "investment" in your home. Though some projects add value, they won't pay for themselves, let alone offer any kind of return. (For a more detailed analysis, read "Remodeling? It's a waste of money.")

Home-improvement projects are mostly consumption spending, and we should pay for our consumption with cash. If you decide to finance, borrow no more than half the cost of the project, and make sure it really is adding value to your home.

Also note: Home repairs and maintenance typically don't add any value to your home. These projects simply maintain the value of your home and should definitely be paid for in cash. If an emergency repair is required and you don't have enough saved, make sure you quickly repay any home equity you use.

Bottom line: Restrain yourself. Try to pay cash for most projects.

Debt consolidation

For too many families, using home equity to pay off credit cards and other debt is a serious mistake.

You're not fixing the problem that caused you to overspend in the first place, and you're likely to just continue racking up debt. But now you've put your home on the line and have turned bills that could have been erased in bankruptcy into secured debt, which can't be whisked away.

A better option could be a three-year fixed-rate personal loan from a credit union. The rate you pay would be higher than what you would pay for secured debt, but you wouldn't put your home at risk.

If you can't pay off the debt within three years, then you should explore credit counseling, debt settlement or bankruptcy.

The only time you should consider using home equity to consolidate debt is if your debt is small (that is, you're at no risk of bankruptcy), you've made permanent, profound changes to your spending and you're absolutely sure you won't carry credit card debt again.

Bottom line: Explore other solutions -- up to and including bankruptcy -- before you use home equity to consolidate debt.

Buying a car

Cars lose value, which means you ideally shouldn't use home equity to pay for them. (See "The real reason you're broke.") You generally should borrow only to buy assets that can appreciate or rise in value. Besides, current auto loan rates average a bit less than fixed-rate home equity loans. Some dealers and manufacturers offer financing deals that are even less than variable home equity line of credit, or HELOC, rates, for those with good credit.

If you do use home equity, don't simply make the minimum payments. Pay off the loan as quickly as possible. Otherwise you could end up paying for a vehicle 10 years after it hits the junkyard.

Bottom line: Try to pay cash for cars. If you must finance, limit your loan to no more than 48 months and consider other alternatives, such as a credit union loan, before tapping equity.

Covering emergency living expenses

Many financial planners have their high-earning clients set up HELOCs to supplement their emergency funds. That way, an extended period of unemployment or other large financial setback is less likely to wipe them out.

As the number of long-term unemployed hits a record (5.9 million people have been out of work 27 weeks or more, the most since the Labor Department started keeping track in 1948), the value of such a precaution has become clear.

Obviously, you don't want to drain your home equity unnecessarily. The first thing you should do when a job loss is imminent is to slash your expenses. But even the most frugal family eventually can exhaust its emergency funds, and the HELOC can provide a welcome backup.

Bottom line: Open a HELOC, but keep it unused so you can tap it in an emergency.

Paying for vacations, computers or other general spending

I won't dignify this bit of foolishness with much commentary.

Bottom line: Just. Say. No.

Investing

Another popular bit of advice during the real-estate boom was to tap the equity that was "just sitting there" in your home and "put it to work for you" through various investments.

But borrowing money to invest is risky business, as many novice stock and real-estate investors eventually discovered. They found themselves with investments that were either worthless or worth far less than the money they borrowed.

The key is to carefully assess the risks as well as the potential rewards. Using home equity to expand a successful business or buy a profitable rental (one with income that exceeds its expenses) can make sense. Tapping your equity to invest in penny stocks or an unproven startup doesn't.

Bottom line: Before putting your home at risk, make sure you have a sound business plan and have explored other financing options.

Paying education costs

Covering college tuition is often cited as a good use of home equity, but the reality is more complex.

Relatively cheap rates on home equity lines of credit can lull parents into a false sense that they can afford to pay for college educations that are actually too expensive for the family budget. If rates climb -- and they likely will as the economy recovers -- the overextended family could lose its home.

There's another option for many families. The federal PLUS loan program allows parents or graduate students to borrow the full cost of an education, minus any other financial assistance. The loans have flexible repayment options, the interest may be tax-deductible (although deductible is more limited than with home equity borrowing), and rates are fixed between 7.9% and 8.5.

Those rates are comparable to what lenders are charging, on average, for fixed-rate home equity loans: 8.32%, according to Bankrate.com. Rates are closer to 5% for home equity lines of credit, but those variable rates can shoot up at any time. Payments on HELOCs are typically interest-only for 10 years, but then the loan switches to a principal-and-interest payment for 10 to 20 years to pay off the balance, which also will cause the payment to jump. (In general, if you're going to need more than a few years to pay back a loan, you'll want to fix the rate.)

Plus loans have a 4% loan fee that's deducted from disbursement checks. Also, PLUS borrowers have to pass a credit check and can be denied if they're 90 days or more past due on a debt, are in default or foreclosure on a loan or have a bankruptcy discharge or write-off of a federal education debt during the past five years. Some parents get around this by finding a creditworthy co-signer or making a case for extenuating circumstances (such as a job loss that put them temporarily behind).

The calculations of home equity versus PLUS loans are complex enough that you might want to consult a tax pro or financial planner. In general, the higher your income and the quicker you can pay off the debt, the better the home equity option looks. If your tax bracket is lower and you'll be carrying the debt for a while, though, PLUS might be the way to go.

Either way, don't borrow too much. You total debt payments, including mortgage, shouldn't exceed 40% of your gross income. If your education borrowing would push you above that limit, you're taking on too much debt and your student needs to consider other options, such as a less expensive school.

Bottom line: Consider federal PLUS loans as an alternative, and run the numbers before you borrow.

( msn.com )

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