Deciding whether or not to use the equity in your home to pay off unsecured debt and/or make home improvements can be a difficult financial decision. The potential for low annual percentage rates and streamlined monthly payments can make second mortgages extremely attractive. However, using your home for collateral is a decision that should be weighed carefully.

Home Equity Loan or Home Equity Line of Credit (HELOC)

Second mortgages come in two basic forms: home equity loans and home equity lines of credit (HELOCs). They typically offer higher interest rates than primary mortgages because the lender assumes greater risk. In the event of foreclosure, the primary mortgage will be repaid before any second mortgages. 

However, because the loan is still collateralized, interest rates for second mortgages are usually much lower than typical unsecured debt like charge cards, credit cards, and consolidation loans.

The other major advantage of second mortgages is that at least some of the interest is, for borrowers who itemize, tax deductible. To receive the full tax benefit, the total debt on your home--including the home equity loan--cannot exceed the market value of the home. Check with your tax advisor for details and eligibility.

Is a second mortgage a good idea?

Before you decide which type of second mortgage is best for you, first determine if you really need one. If you have ongoing spending issues, using the equity in your home may not help and may, in fact, be detrimental. Ask yourself the following:

• Do you frequently use credit cards to pay for household bills?
• If you subtract your expenses from your income, is there a deficit?
• If you were to pay off your creditors by using the equity in your home, would there be a strong possibility of incurring more unsecured debt?

If you responded “yes” to any of the preceding questions, tapping out the equity in your home to pay off consumer debt may be a short-term solution that can put your home in jeopardy of foreclosure.

If you use the equity in your home to pay off your unsecured debts then run up your credit cards again, you could find yourself in a very difficult situation: no home equity, high debt, and an inability to make payments on both your secured and unsecured financial commitments. Spending more than you make is never a good reason to use the equity in your home.

How do I get started?

If you have determined that using home equity is sensible, your next step is to understand the process of obtaining a second mortgage and to choose between a home equity loan and a home equity line of credit.

Factors to consider.

One factor to consider when shopping for a second mortgage is closing costs, which can include loan points and application, origination, title search, appraisal, credit check, notary and legal fees.

Another decision is whether you want a fixed or variable interest rate. If you choose a variable rate loan, find out how much the interest rate can change over the life of the loan and if there is a cap that will prevent the rate from exceeding a certain amount.

Annual Percentage Rate (APR).

Shopping around for the lowest APR (Annual Percentage Rate) is integral to getting the most out of your loan. The APR for home equity loans and home equity lines are calculated differently, and side by side comparisons can be complicated. For traditional home equity loans, the APR includes points and other finance charges, while the APR for a home equity line is based solely on the periodic interest rate.

Other factors.

Before you make any decision, contact as many lenders as possible and compare the APR, closing costs, loan terms, and monthly payments. Also inquire about balloon payments, prepayment penalties, punitive interest rates in the event of default, and inclusion of credit insurance.

When shopping for loans, do not rely on lenders and brokers who solicit you – ask fellow workers, neighbors, and family members for dependable leads, and research the Internet for immediately accessible quotes.

Home Equity Loans.

With a home equity loan, you will receive the cash in a lump sum when you close the loan. The repayment term is usually a fixed period, typically from five to 20 years. Usually, the payment schedule calls for equal payments that will pay off the entire loan within that time.

Some lenders may allow you to borrow up to the amount of equity you have in your home – the estimated value of the house minus the amount you still owe. You are not required to borrow the full amount but can instead borrow only what you need.

Interest rates are usually fixed rather than variable. You might consider a home equity loan rather than a home equity line of credit if you need a set amount for a specific purpose, such as an addition to your home, or to pay off your entire unsecured debt.

Home Equity Lines of Credit.

A home equity line is a form of revolving credit. A specific amount of credit is set by taking a percentage of the appraised value of the home and subtracting the balance owed on the existing mortgage. Income, debts, other financial obligations, and credit history are also factors in determining the credit line.

Once approved, you will be able to borrow up to that limit. Terms and conditions regarding how the funds can be accessed are outlined in the loan documents.

Interest is usually variable rather than fixed. However, the repayment term is usually fixed and when the term ends, you may be faced with a balloon payment – the unpaid portion of your loan.

The advantage of a home equity line of credit is that you can take out relatively small sums periodically, and interest will only be charged when you deduct the money. The disadvantage is the temptation to charge indiscriminately.

Watch out for too-good-to-be-true offers.

You may be tempted by offers that allow you to borrow up to 120% of your home’s equity. Be aware that any interest above the home’s equity limit is not tax deductible. Additionally, you won’t be able to sell your home until the lien is satisfied, which can negatively impact the marketability of your home.

Finally, if you suddenly change your mind, federal law gives you three days after signing a home equity loan contract to cancel the deal for any reason.