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Home Equity Loans: Pros and Cons

Obtaining a home equity loan is a common method of refinancing debt and it has several advantages. But there are a few potential 'gotchas' that are worth considering before taking the plunge.

First, what is a 'home equity loan'? The basic idea is simple: obtain a line of credit, secured by the equity in your home. That is, if you have a certain amount of ownership in your house - say, as a result of having made a down payment or payments over a long time (as many homeowners do) - borrow against that equity.

Many homeowners will take out a HELOC (Home Equity Line of Credit), as they're called, in order to use the money for the purpose those loans were invented: financing home improvements. That purpose gave the loan its original name. But, because of tax implications and other reasons, the HELOC evolved to serve other purposes.

Interest paid on most kinds of debt is not tax deductible, but interest paid on a home loan is. Hence, interest paid on a HELOC can actually be a form of less expensive debt.

Suppose, you have a 12% HELOC for up to $10,000. With most HELOCs you don't actually borrow the entire amount at once. You draw on it, much as you would a credit card, as needed and desired.

So, you have multiple benefits. You can borrow only what you need - keeping the payments and the interest owed as low as possible. And, you get to reduce your taxes by a percentage of the interest paid per year.

If you had a credit card that charged 12% APR, the advantage is clear. You pay a net lower amount of money to the lender as a result of using a HELOC rather than a credit card to finance your purchases.

But, like any loan, it's important to remember that a home equity loan is just that - a loan, or debt. If one of your major problems is the inability to exert the will to refrain from spending beyond your means, you have just found another supplier to feed your addiction. As a result, a home equity loan may actually make your more fundamental problem worse, rather than better.

But, if you have made a commitment to control your debt, and are seeking ways to reduce your overall expenses, a home equity loan can be a sensible method to employ.

One essential exercise is to actually calculate how much money you would be spending per month - and over the life of the debt - in one scenario versus the other. There are debt calculators readily available online to help you do just that.

Sometimes you will have to weigh whether you prefer to spend more money over the life of the debt as opposed to having a smaller monthly payment, but higher total amount of interest. The better calculators will help you run through both scenarios, changing amounts to help you weigh the pros and cons.