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Things to consider when taking a loan or line of credit

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One tool many people are using to pay off their debts is the home equity loan or a home line of credit.

In an expensive housing market like San Diego, where many homes have greatly appreciated in value over a short time, the gap between the purchase price of the home and the home's current value can be a large sum. This amount can be borrowed and used at your discretion, and the interest for home equity loans and lines of credit are fairly low, especially when compared to the average credit card interest rate of around 14 percent (for those with good credit). Additionally, the interest payments are tax-deductible.

Debt-Free America weighs in on whether or not using the equity in your home to pay off debts a good idea below.

People take out these types of loans for a variety of reasons. The top reasons to borrow money from your home are for home improvement projects and debt consolidation.

Debt consolidation allows you to borrow money from your home to pay off your credit cards and other unsecured debts. Often times, people will also take out lines of credit to pay for such things as college tuition, medical bills, big-ticket items such as a car or boat and living expenses during periods of unemployment.

This tactic can be a risky move, particularly if you are using the money to pay off unsecured debts, and it seems that often times the cons of taking out a home equity loan outweigh the pros.

Pros

* Tax-deductible interest payments;

* In most cases, borrowers can deduct the interest on loans up to $100,000 on their taxes;

* Lower interest rates;

* When compared to traditional credit cards and unsecured personal loans, home equity loans carry lower interest rates;

* Various uses; and

* The money from the line of credit can be used for a lot of different things such as personal debts, college tuition or unpaid medical bills. You ultimately have control over the use of that money.

Cons

* Your home is the collateral -- Because the loan is secured with your home, if you fail to make payments on the loan, your house will be taken from you in order to pay the debt off, and your home is usually your largest asset (not to mention something you really just don't want to lose!) This is particularly important to consider if you plan on paying credit card debt off with the loan. If you are in a position where you need to seek out help for your debts, using your most important asset is not wise. If you cannot make payments to your credit cards, they cannot take anything from you to collect, where the home equity lender can take your home.

* A risky spending tool -- Home equity loans can be a risky spending tool for younger homeowners who are not established in their careers and have less experience owning a home. Also, these individuals have less experience managing money and they often run up credit card debt again, and then end up in worse trouble than when they started.

* More interest charges and variable interest rates -- Paying off debts with the loan will decrease your monthly payments, however it will take longer to pay the debt off, which means paying more in interest. You could easily end up paying a lot more in the long run. Additionally, your monthly payments can possibly increase due to variable interest rates, which can hurt if your income does not increase to accommodate the change.

* Home values are not set -- If your home's value decreases, rather than increases, you could end up owing more than the house is worth -- a bad deal if you want to sell your home at some point.

It is important to be sure you explore all of your options and shop around before you consider refinancing your home. You should talk with at least one bank, one savings and loan and one credit union. These companies will more than likely have better deals than finance companies.

Secondly, beware of some lenders targeting homeowners who have low incomes, credit problems or are elderly. These lenders are called "predatory lenders" and deceive consumers about loan terms or give them loans they cannot afford to repay. Many times they will offer loans based on your home equity and not on your ability to repay the loan.

Make sure you read all of the information on the loan application and if the lender pressures you into applying for a loan or something more than you need and/or does not disclose required information or tell you not to bother to read something, be cautious; most likely that is a red flag of a predatory lender. Also, the cost of obtaining a loan from a high-cost lender can be quite excessive and abusive.

Things to consider

Interest rate payments -- Make sure you understand the monthly payments and make sure you can afford to pay them. Also, make sure you know the annual percentage rate (APR) and if it will change during the life of the loan. The APR is one of the most important things to compare when shopping for a loan.

Term of loan -- Make sure you know how many years you will have to repay the loan.

Balloon payments -- A balloon payment is one, large, final payment after a series of lower payments. When the balloon payment is due, you must pay the entire amount, and you should make sure you would be able to handle making it. In most cases, a balloon payment cannot be due in less than five years.

Points and fees -- If points and fees are more than 5 percent of the loan amount, ask why, because traditional financial institutions charge between 1 percent and 3 percent. Also, lenders and brokers may charge points or fees that you must pay at closing or add on to the cost of the loan, or both, and these charges may not be refundable if you refinance or pay off the loan early. Points are usually paid in cash at closing but can also be financed. Be aware that if you finance them, they become a part of the total balance owed and you will therefore be charged interest on them, increasing the total cost of your loan. So it is a good idea to avoid this.

Penalties -- Many lenders penalize those debtors that make a payment late or miss a payment, so it is a good idea to find out what the penalties for this are. Also, check into prepayment penalties and see if there are extra fees that are due if you pay off the loan early by refinancing or selling the home.

The bottom line is that home equity loans are OK if you are a good personal financial manger. But, if you are using your home equity loans to pay off large amounts of unsecured debt because you can't handle it anymore, using your biggest and most important asset is not the wisest choice because you run the risk of losing your home. This is only worsening a potentially serious situation.

Don't feel bad if you can't get your budget or your debt under control. It is also important to realize that there are many options out there other than obtaining a home loan to pay off debts. Many consumers are even unaware that they can talk to their own creditors, who may be more willing to work with them than they realize. Many will offer short-term hardship programs that will allow you to get back on your feet. A debt management program may also be a good option; your credit card terms can be re-negotiated to help you through any financial hardship.

Financial advisors at Debt-Free America are available to discuss your budget and expenses with you, at no cost. They have had years of training and education in the budgeting and credit card industry and are available to use as a free resource.

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