PERSONAL FINANCE : FIRST STEPS : HOMING IN ON CASH : Tapping Your Equity Has Promise, Pitfalls

If you need money to start your own business, meet college expenses or make some other worthy investment, your best source of cash may be right under your feet--the equity in your home.

But while borrowing against your equity can provide important tax deductions and low-cost financing, it’s important to remember that you’ll lose your house if you don’t pay the money back.

“You’re putting up serious collateral, so only do it for serious reasons,” says Lawrence A. Krause, president of the San Francisco financial planning firm that bears his name. In addition to starting your own business or paying college costs, other good reasons to tap your equity include meeting major medical expenses or remodeling your house.

If you can justify borrowing against your equity, you’ll have to sort through a host of loan products to find one that’s right for you. They range from credit lines you can tap with a check to the relatively obscure reverse mortgage, with several others in between.

Here are your major choices:

- Home equity credit line. The most heavily promoted loan, it’s basically a revolving line of credit usually equal to 70% or 80% of the equity in your property. You access the money by using a special credit card or checks linked to the account.

Lenders say you can’t beat credit lines when it comes to ease of access, and they’re great if you can use the money to pay off higher-interest credit card debt and retain important tax deductions for mortgage interest. Monthly payments are sometimes lower than those on charge accounts, in part because the money doesn’t have to be paid back for several years.

But what lenders see as attributes, financial planners see as dangers.

“That easy access can turn into a curse if you don’t have much discipline when it comes to spending, and the longer repayment schedule could cost you far more than a credit card loan you pay off more quickly,” says Phil Kavesh, a partner in the Torrance-based financial planning and accounting firm Kavesh & Gau.

Many credit lines entail big start-up charges that raise the true cost of the loan, and maintenance fees can top $100 a year.

Most of the lines also have adjustable rates that can ratchet upward with inflation, and some must be repaid with a lump-sum balloon payment when the term of the loan expires. “If the balloon payment is due and you can’t come up with the cash, you’ll have to refinance or sell your house in order to pay off the loan,” Kavesh says.

Still, credit lines are useful if you can control your spending. You might also want to set up a line if you don’t have much “emergency money” tucked away to see you through the loss of your job or some other financial calamity.

- Conventional home equity loan. This is a no-frills second mortgage for those who don’t like the uncertainty of variable-rate credit lines. You get the money in one lump sum, and typically pay it back at a fixed interest rate in fixed monthly installments.

Rates on fixed “seconds” are higher than rates on most adjustable credit lines--at least for now--but some borrowers feel that’s a fair exchange for the security of locking in a set rate for the life of the loan.

Repayment schedules on seconds are usually longer than those for credit line loans, which also lowers your monthly payments. “And most are fully amortized, so you don’t have to worry about coping with a balloon payment several years from now,” Kavesh says.

Lenders will usually give you a home equity loan once you have a 20% or 30% equity stake in your property. Under tax code changes made last December, most homeowners can deduct interest charges on up to $100,000 of home equity borrowing, regardless of how the money is spent. The rule applies to both credit lines and conventional seconds.

If you borrow more than $100,000, you can deduct only the portion above $100,000 if it’s used for home improvements. Generally, debt that doesn’t qualify is treated as “personal debt,” and only 40% of it can be deducted on your 1988 return.

- Home improvement loan. This kind of loan is usually taken out by a borrower who wants to fix the place up but has an equity stake of less than 20%.

Most lenders are willing to make home improvement loans to borrowers with small amounts of equity because they calculate what the property will be worth after the improvements are made. Since most remodeling jobs will raise the property’s value, the lender figures that it will have adequate protection if it must eventually foreclose.

The big drawback to home improvement loans is that most lenders release the money in chunks. Each time the borrower asks for funds, the lender sends a representative out to the job site to check on the progress.

“I’d recommend taking out a straight home equity loan if you possibly can,” says Tom Criser, a vice president with Van Nuys-based Valley Federal Savings & Loan Assn. “The cost is about the same, but you can get the home equity loan faster and with fewer hassles.”

- New first mortgage. The simplest and sometimes cheapest way to tap the equity in your home is to refinance with a new first mortgage. If a borrower with a $150,000 home and a $40,000 loan at 10% wanted to borrow an additional $60,000, it could be cheaper to refinance with a new first mortgage of $100,000 at the current rate of 10.5% than it would to keep the old 10% loan and take out a $60,000 second mortgage at the current 11.25%.

Refinancing might also make sense if you can get a much lower rate than the one you’re currently paying or if stretching out your payments over a new 30-year term would lower your monthly housing outlays and free up cash needed for other purposes.

Under the new tax rules, a refinancing is treated like a home equity loan, but the balance of the prior mortgage isn’t counted against the $100,000 limit. So if the balance on your current mortgage is $45,000, you can borrow up to $145,000 and still fully deduct all the interest.

“But if you refinance for more than your existing loan balance plus $100,000, deductions for the overage may be limited,” warns Don Stearns, senior tax partner in the Los Angeles office of Kenneth Leventhal & Co., a real estate consulting and accounting firm. With few exceptions, the excess can only be deducted if it’s used to fix up your home; the rest is considered personal debt and only a portion of the finance charges can be written off.

- Reverse mortgage. This can be a valuable tool if you’re older and simply want extra cash to meet expenses. It’s basically a home loan that works backward: Instead of getting a single lump sum that you’ll repay over several years, the loan is advanced to you in monthly increments.

The typical reverse mortgage lasts for 10 years. You pay back nothing until the term expires, but then all the advances and interest must be repaid in a lump sum.

These fixed-term reverse mortgages attract homeowners who need monthly income until Social Security checks or a pension kicks in. They’re also useful for cash-strapped owners who want to stay in their house a few more years before moving into a retirement spot.

However, they’re a poor option for people who want to stay in their house after the loan falls due because the home will likely have to be sold to satisfy the debt.

Before you agree to borrow money against your house, don’t forget to explore other sources of low-cost financing. You may be able to borrow from a credit union--or against a life insurance policy or company pension--at rates far below those on home equity loans. A low-interest student loan could finance a college education, while the government might help you set up a business.

Should tapping your equity still makes sense, talk your options over with a financial planner or accountant.