Tapping Into Home Equity the Right Way -- and the Wrong Way

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AOLA lesson of the recent real estate bust is that turning home equity into cash must be done with great care.

By Teresa Mears

With home values rising, more Americans have equity in their homes. That has generated plenty of cheers from homeowners, and it's also brought back the home equity line of credit as a popular option for the first time since before the Great Recession. Americans took out $23.4 billion in home equity lines in the first quarter of 2014, up 15.5 percent from 2013 and the highest number in six years, according to Equifax, a credit reporting agency.

If your mortgage is less than 80 percent of your home's value, you might want to join that group. But the greatest lesson of the recent real estate boom and bust is that turning home equity into cash is%VIRTUAL-pullquote-"Equity is really an ethereal thing. In a sense, it's not real."% best done with great care. "The mortgage mess and the real estate recession gave us some really good lessons in how home equity lending could go bad," says Liz Weston, a personal finance columnist and author of "Deal with Your Debt: Free Yourself from What You Owe," and other books. She cited a 2011 CoreLogic study that found that borrowers with home equity loans or lines of credit were significantly more likely to owe a larger amount than their homes were worth.

"We shouldn't forget those lessons now that many people have equity again, and that banks are allowing us to tap it. Your home equity is a precious resource that shouldn't be squandered," Weston says.

[Read: Could You Finance Your Retirement With a Reverse Mortgage?]

There are times that having a home equity line of credit is a smart financial move. It's hard to find a loan at better rates -- less than 4 percent for borrowers with good credit -- and qualifying for a home equity line of credit is easier than it is for a business or personal loan. Having a home equity line of credit but using very little of it can help prepare for emergencies, Weston says.

"Even a fat emergency fund can get drained by a big-enough financial setback, and most people don't have a fat emergency fund," she says. "The key, though, is, again, not to squander that equity. You want it there for you when you need it. If you're such a spendaholic that you can't trust yourself not to use the line, then of course you shouldn't set one up."

Using home equity line of credits to finance cars and vacations is generally a bad idea, financial experts say. Using the line to fund a child's education might be a good idea, but only if you can pay it back in five to 10 years.

"I think what we learned with the last housing boom is that there's a danger in tapping home equity," says Daren Blomquist, vice president at RealtyTrac, which tracks and analyzes housing data. "That equity is really an ethereal thing. In a sense, it's not real."

Property values have risen significantly in the last few years, which has added to Americans' home equity, but while home values have increased, the pace of growth is now slowing, he says. "You have to be careful you're not treating that home equity as an unlimited source of funds," Blomquist says.

[Read: Should You Buy a New Home Before Selling Your Current One?]

The safest use of home equity funds is for home improvements that will add to the home's value. If you spend $50,000 on a home addition that adds $50,000 to your home's value, you've broken even -- though you still have to make payments on the money you borrowed.

During the real estate boom, many investors, and even some individual homeowners, drew on their home equity to buy additional properties, keeping these properties heavily mortgaged. When home values dropped, many investors lost all their properties due to the risky real estate game they were playing. "Leverage can be an amazing tool for an investor, but it can also be an entirely dangerous%VIRTUAL-pullquote-There are actually three ways to draw on your home equity.% tool as well," Blomquist says.

If the only funds you have to draw on for investment are your home equity, you may want to reconsider, Weston says. "Home equity lines can be a cheap source of credit, but you're putting your home at serious risk," she says. "The only way it makes sense to me to borrow to invest is if you have enough savings to pay off the debt in a hurry if you have to."

There are actually three ways to draw on your home equity: Do a cash-out refinance, take out a home equity loan or get a home equity line of credit. In all three cases, most lenders won't let you borrow more than 80 percent of your home's value.

Refinancing restarts the home mortgage clock and has higher costs but low interest rates, currently about 4.12 percent for a 30-year, fixed-rate loan. A home equity loan, sometimes called a second mortgage, usually has a fixed rate (Bankrate.com listed rates from 3.24 to 8.99 percent for a $30,000 loan) and a set time to pay it back, generally with equal monthly payments

A home equity line of credit is more like a credit card. The lender sets a maximum you can borrow, and you can draw money as you need it, though many home equity line of credits require an initial draw. The interest rate varies daily, and is usually prime plus a set number, but the required payment is usually interest only.

[See: 10 Tips to Sell Your Home Fast.]

After a certain number of years, the line of credit converts to a home equity loan, principal becomes due and you can no longer draw on it. The current interest rate starts at less than 4 percent, but that is likely to increase as the prime rate -- which has been 3.24 percent for the last year -- rises.

Here are five questions to ask yourself when considering whether a home equity line of credit is right for you:

Do you need money to fix up your home? If you're planning to sell soon, a home equity line of credit may be the best way to finance improvements, and you can pay it off entirely when you sell. Using a home equity line of credit may also be a good way to finance improvements if you plan to stay in the house, but make sure you're not still paying off this year's paint job when it's time to paint again. "It's a great time to consider renovations, either to improve the quality of life you're experiencing yourself or to improve the potential resale value of that home down the road," Blomquist says.

Do you need a new car? Look for an auto loan from your bank or a credit union instead. Rates are comparable, and you won't put your home at risk if you fail to make the payments.

Do you want to consolidate credit card debt? The big question to ask yourself is whether you're likely to go into debt again. Using your home equity to pay routine bills is not financially smart. But if your credit card debt is at high rates and was incurred because of a setback you've now recovered from -- such as unemployment or serious illness -- a home equity line of credit might be a way to pay less interest. However, if you don't pay credit card bills, you still have your home. If you can't make your equity line payments, your home is at risk.

A home equity line might be a good idea if you anticipate having an increase in income that will enable you to pay off the debt quickly. However, if you're nearing retirement, your mortgage balance is high and your income is declining, you might be better off encouraging your child to take out his or her own student loans.

Are you starting a business? A home equity line of credit might be a good way to raise needed capital. But before you put your home at risk, make sure you'll be able to pay off the debt if your business fails.