Securing a home equity credit line has pros, cons

By JEFF BROWN.- After watching an unemployed friend pay bills by drawing on a home equity line of credit, a reader asks if it's wise to set up a credit line for an emergency fund.
It's not a bad idea, so long as you note the hazards.

A home equity line of credit, or HELOC, is basically a second mortgage on your home, with a floating interest rate that can go up or down each month. If your home were currently worth $300,000 and you owed $200,000 on your first mortgage, you'd have $100,000 in equity that could serve as collateral on a home equity loan.

Of course, this means that if you stop making payments, the lender can foreclose and sell your home to cover the debt, as with a regular mortgage.

To qualify for an equity loan, you generally must prove that you earn enough to make the payments. So if you're thinking about an emergency fund, you'd be wise to get such a loan while you have a job.

Because equity loans are secured by a property, the lender takes less risk than with unsecured loans such as credit cards. That's why HELOCs usually have fairly low interest rates - currently 6 percent to 7.5 percent, depending on the borrower's credit rating.

With a line of credit, you are authorized a maximum amount to borrow, and you can take any amount up to that limit any time you want. HELOCs typically provide borrowers with checkbooks and debit cards. Your monthly statement will show the current debt and minimum payment required, just as a credit card statement would.

A second type of home equity loan, the installment loan, gives the borrower a lump sum when the loan is approved, and the borrower begins making payments right away.
The interest rate is fixed for the life of the loan, as with a traditional mortgage. Although that's an advantage, installment loans are not as suitable for an emergency fund, because you must begin payments even if you have no immediate use for the money.

With both types of equity loans, interest payments on debts of up to $100,000 are generally deductible on the federal income tax return, which is not the case for credit-card loans. That means the real, after-tax rate on a 7 percent equity loan would be 5.25 percent, assuming a 25 percent tax bracket.

To shop for a HELOC, you can go online - but first, some warnings:
Many HELOCs have low introductory "teaser" rates. Focus instead on the annual percentage rate, or APR, which accounts for fees and the true interest rate after any teaser period ends.
Look for the index that will be used to adjust the interest rate every month after the teaser period.

Know the maximum the loan can charge. I saw one that started with a 3.99 percent teaser but could go as high as 24 percent.

Beware of balloon payments. Some HELOCs offer dirt-cheap minimum payments that cover interest only, so that the whole debt remains due some years down the road.
Understand that even if you don't use it, a big line of credit can hurt your ability to get other loans. Lenders worry that you could go on a spending spree and rack up more debt than you can handle.

Jeff Brown is a syndicated columnist for Knight Ridder News. His column appears every Tuesday in The Record.