A home-equity loan, also known as a line of credit, lets homeowners borrow money by leveraging the equity in their homes. 

Here we go over how these loans work and how they may pose both benefits and pitfalls.

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Home-Equity Loans

Home-equity loans are available with terms that generally range from five to 15 years. Normally the loan must be repaid in full if the home on which they are borrowed is sold.

A home-equity line of credit is a variable-rate loan that works much like a credit card and, in fact, sometimes comes with one. Borrowers are pre-approved for a certain spending limit and can withdraw money when they need it via a credit card, cheque or direct transfer. Monthly payments vary based on the amount of money borrowed and the current interest rate. Like fixed-rate loans, the loan has a set term. When the end of the term is reached, the outstanding loan amount is to be repaid in full, although it is possible to refinance the loan.

Benefits for Consumers

Home-equity loans provide an easy - yet dangerous - source of cash. The interest rate on a home-equity loan - although higher than that of a first mortgage - is much lower than on credit cards and other consumer loans. As such, the number one reason consumers borrow against the value of their homes via a home equity loan is to pay off credit card balances. It's also possible that interest paid on a home-equity loan may be tax deductible. So, by consolidating debt with the home-equity loan, consumers get a single payment, a lower interest rate and potential tax benefits.

Benefits for Lenders

Home-equity loans are a dream come true for a lender, who, after earning interest and fees on the borrower's initial mortgage, earns even more interest and fees. If the borrower defaults, the lender gets to keep all the money earned on the initial mortgage and all the money earned on the home-equity loan; plus the lender gets to repossess the property in case of default, sell it again and restart the cycle with the next borrower. From a business-model perspective, it's tough to think of a more attractive arrangement.

The Right Way to Use a Home-Equity Loan

Home-equity loans can be valuable tools for responsible borrowers. If you have a steady, reliable source of income and know that you will be able to repay the loan, its low interest rate and flexibility make it an attractive alternative. Home-equity loans can help cover the cost of a single, large purchase, such a new roof on your home or an unexpected medical bill. It can also provide a convenient way to cover short-term, recurring costs, such as the fees for your child's high-school or university education.

Recognising Pitfalls

The main pitfall associated with home-equity loans is that they sometimes seem to be an easy solution for a borrower who may have fallen into a perpetual cycle of spending, borrowing, spending and sinking deeper into debt. Unfortunately, this scenario is so common the lenders have a term for it: reloading, which is basically the habit of taking a loan in order to pay off existing debt and free up additional credit, which the borrower then uses to make additional purchases.

If you are contemplating a loan that gives you access to credit to pay off your debt, it might be time for a reality check. Were you unable to live within your means before you took out the line of credit? If so, it will likely be unrealistic to expect that you'll be better off when you increase your debt by 25%, plus interest and fees. This could become a slippery slope to bankruptcy.

Another pitfall may arise when homeowners take out a home-equity loan to finance home improvements. While remodelling the kitchen or bathroom generally adds value to a house, improvements such as a swimming pool may be worth more in the eyes of the homeowner than the market determining the resale value. If you're going into debt to make cosmetic changes to your house, try to determine whether the changes add enough value to cover their costs.

Paying for a child's university education is another popular reason for taking out home-equity loans. If, however, the borrowers are nearing retirement, they do need to determine how the loan may affect their ability to accomplish their goals. It may be wise for near-retirement borrowers to seek out other options with their children.

Should You Tap Your Home's Equity?

Food, clothing and shelter are life's basic necessities, but only shelter can be leveraged for cash. Despite the risk involved, it is easy to be tempted into using home equity to splurge on expensive luxuries. To avoid the pitfalls of reloading, conduct a careful review of your financial situation before you borrow against your home. Make sure that you understand the terms of the loan and have the means to make the payments without compromising other bills and comfortably repay the debt on or before its due date.