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Time to Back Away From the HELOC?

NEW YORK ( TheStreet) -- With interest low during the past few years, the home equity line of credit was a good option for many homeowners looking to raise a little cash. Not only were rates low; there wasn't much chance rates they would spike anytime soon.

But now things are changing, with an improving economy likely to usher in higher interest rates. That could drive up future charges on HELOCs issued today. For those concerned about this, the fixed-rate home equity installment loan could be a safer bet.

These loans are similar to fixed-rate mortgages, with the interest rate guaranteed not to change for the life of the loan. Currently, rates average from just over 5% for a three-year loan to 6.3% for a 15-year loan, according to the BankingMyWay.com survey.

Yes, you would pay less for a HELOC, which, like a credit card, would allow you to draw as little or as much as you chose against your credit limit. Many of these offer initial rates around 3%, according to the BankingMyWay search tool.

But that rate is guaranteed only for the first few months. After that, the rate can adjust as often as every month, usually by adding a couple of percentage points to the prime rate. With prime at 3.25%, a HELOC issued today could quickly charge as much as a fixed-rate installment loan. And if prime were to rise, the HELOC could charge more.

For either type of loan, you must have equity in your home -- it must be worth more than you owe on your mortgage. Because of the collapse in home prices a few years ago, about a quarter of homeowners with mortgages owe more than their homes are worth, making them ineligible for home equity loans. But that leaves three-quarters in the black. And about a third of all homeowners don't have a mortgage, many of them older folks who have paid off their loans.

In other words, there's plenty of home equity out there. Lenders are loosening up and approving loans for applicants who would have been turned down a year or two ago.

Home equity loans are an appealing way to raise money. Because the debt is secured by the home, the rates are lower than for unsecured loans such as credit cards. And most homeowners can deduct home equity interest charges on their federal returns.

Generally, the home equity installment loan best serves borrowers who need a large chunk of cash that will be paid back over a number of years. The installment loan is often used for a major home improvement such as an addition or for college expenses or other expenditures that pay off over the long run.

Lines of credit, on the other hand, are best if you need money only for the short term -- short enough that you don't need to worry about a spike in the rate applied to your balance. Not only are HELOC rates lower at the start than those for installment loans, but the required monthly payment covers only interest, allowing the borrower to postpone paying the principal, or outstanding debt. Of course, waiting too long means racking up a lot of interest charges over the years.

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