For Every Loan, a Proper Use

David Stevens has seen it countless times: Homeowners who want to finance a major renovation, pay down their credit card debt or take a once-in-a-lifetime vacation come into their mortgage lender's office and announce that they would like to apply for a home-equity loan.

The problem is, what these homeowners actually want may be an entirely different product.

Stevens sees it as part of his job to find out whether homeowners really want that home-equity loan, which acts as a fixed-term second mortgage, or are actually seeking a home-equity line of credit, a product that operates like a credit card.

"We have to be very careful to find out exactly what these customers are asking for and how they want to use their money," said Stevens, president of affiliated businesses for Long & Foster in Fairfax. "Then we can help them decide whether they want a home-equity loan or a home-equity line of credit."

There's debate over whether it's wise to do so, but U.S. homeowners rely on home-equity loans and lines of credit to handle financial emergencies as well as more frivolous purchases. The interest rates are usually lower than on credit cards and other types of unsecured consumer debt. And the interest paid is tax-deductible, to a point. The mortgage-finance company Freddie Mac reported that consumers took out $60 billion in cash from home-equity loans in the third quarter of 2007.

A home- equity loan is a second mortgage, usually in the form of a note that sits behind the homeowner's primary mortgage. The amount of money that consumers can get with these loans -- in a lump-sum payment -- is based on how much equity they have in their residences.

Most lenders require that a homeowner have at least 10 percent equity in his or her residence before granting a home-equity loan or a home-equity line of credit.

Home-equity loans generally come with a fixed interest rate, fixed monthly payments and a specific life span, usually five to 15 years. They operate much like a fixed-rate, first-mortgage loan.

But the interest rate on home-equity loans is higher than on first mortgages. That is because lenders assume greater risk with second loans: If the borrower defaults, the lender of the first mortgage gets money before the second lender does. Because of this, borrowers usually receive better interest rates on home-equity loans if they have better credit and have built up more equity in their homes.

This week, the national average interest rate on a home-equity loan was 7.99 percent, according to Bankrate.com, compared with less than 6 percent for most first-mortgage loans.

A home- equity line of credit is different. It's helpful for homeowners to look at it in the same way they would view a credit card.

These products, often referred to as HELOCs, are open-ended loans paid as revolving debt. Unlike credit cards, though, HELOCs use homeowners' residences as collateral. As with home-equity loans, the amount of money homeowners can borrow depends on the amount of equity they have built up.