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Taking A Home Equity Loan?

Home equity loans and lines of credit have always been a popular way to take advantage of a home's assets.

Today, more people than ever have these loans, and the amount of cash they borrow is growing.

Before you put that loan money to use, there are some important dos and don'ts you should know. Financial advisor Ray Martin explains on The Early Show.

Not only are more people taking out such loans, they are taking out bigger loans. For example, the average home equity line of credit has climbed from $30,400 to over $36,600 in the last year.

Martin believes there are three reasons behind the increasing popularity of these loans. Rising home values mean that people suddenly have more equity in their homes and they are taking advantage of that equity through home equity loans and lines of credit, which are "cheap money" now, thanks to low interest rates. Also, these loans are fairly easy to obtain.

It's important to understand the difference between a home equity loan and a home equity line of credit. Both are tied to the equity in your current home.

If your home is worth $200,000 and you have a mortgage of $100,000 then you potentially can borrow $100,000 against your home. But, if you fail to pay off your home equity loan or line of credit, you risk losing your home to the bank. Basically, the similarities end here.

A home equity loan is sometimes referred to as a second mortgage. You borrow a certain amount at a fixed interest rate and you pay it back, just as you would a mortgage.

A home equity line of credit is more like a credit card. You are approved to borrow a certain amount, but you don't have to borrow it all at once. Instead, you borrow it as you need it and pay it back accordingly. Unlike a home equity loan, lines of credit do not have a fixed interest rate.

The general rule of thumb when deciding if you should obtain a loan or line of credit is this: if you are borrowing money that you will be able to repay over the next two or three years, get a line of credit because you will most likely be offered a lower interest rate. However, if you expect the loan to be longer term, get a home equity loan instead so you can lock in a guaranteed interest rate.

People take out home equity loans and lines of credit for a variety of reasons. No matter which type of loan you choose, there are certain things you should never ever use the money for. For instance: weddings, furniture, drapery, vacations, and meals. None of these items has a lasting financial value. Using the equity in your home to buy them is called stripping yourself of equity. Your home's equity is an asset. When you use it to buy things that don't appreciate in some way, you are basically throwing that asset away.

Instead, only use the equity in your home to buy or invest in another asset. For example:

College Education: You are investing in "intellectual capital." You are allowing yourself or you child to potentially earn more money down the road.

Home Remodeling: Updating a kitchen or bathroom will increase the value of your home.

Car: This is not the best use of a home equity loan but it's acceptable because the car will keep its value for a long period of time.

Credit Card Debt: This is a very common use for home equity loans and it's a great idea. The interest rate on your home equity loan or line of credit is bound to be significantly lower than the rate on your credit card. You can save yourself a lot of money by using the loan to pay off your credit card debt and then re-pay the bank at a lower interest rate. BUT you must commit to paying back the loan or line of credit. And, while paying off your credit card is a temporary solution to getting rid of debt, it does not address the root of your debt problem: why do you have so much debt in the first place?

"Surveys indicate that 71 percent of homeowners who use a home equity loan to pay off their credit cards end up back to their old spend-and-charge habits," Martin says. "Any individual who gets a home loan to bail them out of financial difficulty should also work out a plan to address the root of the problem."

Spendthrifts should really get their spending under control before tapping into their home equity and putting their home at risk.

Using the equity in your home to help you acquire other assets sounds like a great deal. However, many consumers don't realize that a bank can decide to "block" their line of credit.

Banks have the right to revoke your line of credit if your "financial situation changes" - in other words, if you suddenly become a big risk to them. Banks typically don't keep tabs on your financial situation, Martin says, as long as you pay them on time. However, if you are late, you arouse suspicion and run the risk of losing your access to more cash.

Practically every bank offers home equity loans and lines of credit. When shopping for a line of credit, look for one that's advertised as "prime minus." That means that the rate you are being offered is below the Prime Lending Rate. In other words, it's a good deal.

Also, many loans are being advertised as "free" - you pay no closing costs. Be sure to read the small print associated with these loans. You are typically required to hold the loan for three to five years. If you sell your house - and thus close the loan - you will be charged for closing costs which may run around $1,500.