Homeowners are increasingly relying on their homes and rising property values to increase their purchasing power. They are borrowing against the equity in their homes to pay down credit card debt and auto loans or even to finance vacations or renovations. These loans are more attractive than other forms of credit because, in many cases, you gain some tax breaks on interest. Additionally, because the loan is secured by your home, it will likely have a lower APR. However, home equity loans aren't right for everyone, so make sure you carefully consider the pros and cons before signing on. And remember, before you go loan shopping, see what lenders will see with your free credit report!

There are two basic types of home equity loans: lump sum loans, which work like second mortgages, or home equity credit lines, which work more like credit cards. In both cases, the amount you can borrow is, of course, limited by your actual equity. Equity is calculated by subtracting the unpaid balance of your mortgage from the fair market value of your home.

Up-Front Loans Can Cover Big-Ticket Purchases

With an up-front home equity loan, or second mortgage, you receive the full amount of the loan when it is opened, and pay it back in fixed monthly installments over the life of the loan. Up-front loans can be good for debt consolidation, buying a car, education, major home improvements, or paying large, unexpected bills, such as emergency medical expenses.

Home Equity Lines Allow You to Borrow Only What You Need

More and more lenders are offering home equity lines of credit, which allow you to draw off your loan as you need it, usually by writing a check. Your monthly payment is usually a percentage of the total outstanding principle.

The particular benefit of home equity lines of credit, as opposed to up-front loans, is their flexibility. A credit line like this can be a good way to help pay for a child's education, for example, because you can borrow and pay interest on each year's costs only as they arise. With an up-front loan, you would pay interest on all the money from the very beginning.

Because this flexibility is the key benefit, try to avoid a home equity line that specifies a certain minimum be borrowed every time you draw on the line or that requires an initial cash advance you do not need. Also, unless you have very strong willpower, don't take the "credit card" that some lenders may offer with a home equity line. Carrying it around in your wallet may make drawing on the line too easy and encourage you to borrow more freely than you should.

Examine All Your Options Before Borrowing Against Your Home

With interest rates that are typically lower than many credit cards, a home equity loan can be the best way to finance a large purchase or cover an unexpected expense. But home equity loans and credit lines are more expensive than first mortgages, and may be more expensive than other financing options, such as an auto loan or subsidized student loan. When you consider a home equity loan, think through these issues:

• Does this home equity loan offer the lowest interest I can find to finance this purchase?

• Am I attracted by an introductory rate that is much better than the long-term rate of the loan?

• Will my interest be tax deductible? (The only way to be sure is by consulting a tax advisor.)

• Is the risk of putting my home on the line a worthwhile tradeoff to achieve this financial goal?

Finally, when considering between an up-front loan and line of credit, ask your lender to help you compare the interest rates. Matching up the Annual Percentage Rates alone won't give you an accurate picture, since the APR for a home equity line of credit is based on the periodic interest rate alone. It does not include points or other charges associated with an up-front loan.

A Final Caution

When you borrow against your home, you are securing the loan with collateral your house. If you can't repay, the lender has the right to force foreclosure to receive repayment. That means you'll lose your home and have a foreclosure on your credit report. If you think you may not be able to make the payments when faced with a drop in income, then a home equity loan probably isn't for you. Additionally, if you're consolidating credit card debt, then make sure to keep your credit-card spending under control. If you charge those cards back up, you'll be in a worse financial position than before.

Whether a home equity loan is in your future or you've decided to pursue another form of credit, it's important to check interest rates and fees with a variety of lenders. To protect your credit rating, minimize inquiries on your report by only authorizing credit checks with the one or two lenders you're serious about.