A Risky Way To Reduce Debt

Withdrawing equity from your home may seem like a cheap, an easy way to borrow, but watch out for the pitfalls.

In the final phase of our 'Your Finances in 2012' campaign, we're looking at household budgets. David Kuo, The Fool's resident crystal ball gazer, predicts the typical household could face a budget shortfall of £8,305 in 2012. If this pessimistic forecast is correct, millions of families could be faced with real financial difficulty. What can you do if you're having trouble making ends meet? After all, you can only cut back and budget so much. One seemingly simple solution is to borrow money. For example, if you're a homeowner, you could cash in on the rising value of your home. Lenders often refer to this as 'withdrawing equity' from your property. As the value of your home rises, you can take out a bigger mortgage if you wish. Borrowing in this way appears to be cost-effective as you'll usually be charged a lower rate of interest than you would be on a personal loan. And because you can spread your extra borrowing over a long period for example, 25 years your monthly repayments will be smaller than the monthly repayments on such a loan. But remember a mortgage is secured against your property. If you fall behind on your repayments, you'll be risking the roof over your head. So is withdrawing equity from your home really such a good idea? It's not easy If you're currently tied into a fixed rate, discount or tracker deal, you will have to go cap in hand to your existing lender for a 'further advance'. And some lenders are very strict about the maximum amount they are prepared to lend to you. Nationwide, for example, will allow you to borrow up to 95% of your home's value -- but only if you intend to use the cash for home improvements. If you want to spend it on anything else a luxury holiday or a new car perhaps - the maximum advance is just 85% (subject to Nationwide's approval). Halifax, on the other hand, is a little more generous, allowing you to borrow up to 97% to spend on a whole range of purposes including clearing other debts. Of course, if you are coming to the end of your current deal (or worse, languishing on your lender's standard variable rate), you could simply remortgage, and increase the amount you want to borrow. However, bear in mind that following the credit crunch, if you want to borrow more than 90% of your property's value, it is becoming increasingly difficult to get a cheap rate. Charges and costs You may be expected to pay an arrangement fee for the privilege of withdrawing equity, and this fee can run to several hundred pounds. Halifax will charge £349 and if you're borrowing more than 90% they may insist on revaluing your home which will cost another £100 at least. Nationwide will charge a reservation fee between £0 and £1,999. If you choose not to pay a reservation fee you'll have to pay a higher rate of interest instead. What's more, the chances are that your additional borrowing won't be arranged on the same terms as your original mortgage deal, and so the monthly payments may be higher. Finally, no matter how keen your lender may be to hand over a cheque, remember that the more you borrow now, the more you will have to pay back in interest later. So, for example, if you increased the size of your mortgage by £10,000, you would pay back around £20,000 over 20 years.* Puts that big fat cheque in perspective, doesn't it? Is drawing equity from your home a good way of solving your budget deficit? For non-essential spending, I don't think this is the best move because of the higher overall costs involved in long-term borrowing. You also run the risk of falling into negative equity if you borrow a high percentage of the value of your home and house prices fall. Negative equity means you owe more to your lender than your home is actually worth, That's bad news if you need to sell. That's not to say withdrawing equity is always a bad idea in every circumstance. But if you are considering taking this step, work out your budget very carefully. You don't want to put your home at risk by taking out a larger mortgage than you can afford to pay back. *Based on an assumed interest rate of 8% over 20 years. Use The Motley Fool Mortgage Service to compare competitive mortgage deals. And a final word of warning: Withdrawing equity may affect your entitlement to means-tested benefits. If that applies to you be very careful not to put them in jeopardy. This article was originally sent to Fools as a standalone email in our 2012 campaign.