Use Caution with Second Mortgages

The phrase buyer beware is supposed to keep consumers on their toes whenever they hit the malls or buy online. Homeowners should heed a similar warning-borrower beware-especially when it comes to home equity loans.

The famed webslinger Spider-Man was heavily influenced by the phrase, "With great power comes great responsibility." It reminded him to be prudent in the use of his tremendous super skills.

Homeowners should also take those words of wisdom to heart. Most have access to a powerful source of financing-the equity in their homes. When tapped in the form of a mortgage loan, it can be used to pay college tuition, fund a business start-up, or consolidate debts.

As Spider-Man would tell any homeowner, though, there is great responsibility with this financial clout. Use the money frivolously or choose the wrong loan, and you could pay a hefty price.

Choose the right reason

Refinancing your house to spring for something frivolous like a vacation will be fun and should give you a tax deduction, but it's not a good long-term move. After the suntan fades, the only thing you've done is add principal and long-term interest costs to your house payment.

Instead, use second mortgages for items such as home improvements or to launch a business. These are long-term investments that hopefully will continue to appreciate in value during the time you own the house. If you sell your home, you should be able to recoup the value of the amount you originally borrowed, plus appreciation.

Try to avoid using home equity to finance college tuition. Instead, start investing money from the time your child is born and let an investment's compound interest add to your savings.

Choose the right loan

If you decide to refinance, you'll need to carefully choose your loan. Many people opt to consolidate debts into a first mortgage, such as an adjustable-rate mortgage (ARM) or a loan with a balloon payment. Be careful with these loans. The rate on the ARM will likely adjust upward after the introductory period. With a balloon loan, you'll be required to pay the loan in full at the end of the five- or seven-year introductory period.

The alternative is a second mortgage, such as a home equity line of credit (HELOC) or a home equity loan. These loans have their weaknesses. A HELOC has variable rates, so if rates start to rise, you could find yourself in trouble. A home equity loan has a fixed rate, fixed loan amount, and is probably your safest bet. However, you'll need to make sure that you can afford the payments, and be watchful for any exorbitant fees.

Your home has super-strength when it comes to personal finances. Its equity can give you quick cash when you need it most. But with this power comes great responsibility. If you're going to tap equity, borrow wisely. Otherwise, you'll find yourself in a web of financial trouble from which even Spider-Man can't escape.