NEW YORK (MONEY Magazine) - Last year thousands of Americans discovered a pot of gold in their own living rooms.

Or so it must have seemed: Spurred by historically low interest rates and sky-high housing prices, homeowners took out $223 billion in new loans backed by the equity in their homes in 2003.

Experts say even the interest rate hikes that seem to be on the horizon aren't likely to end the home-equity party. A generation ago homeowners dreamed of writing that final mortgage check and retiring with their homes free and clear; today's pre-retirees are more likely to be juggling multiple refis with the click of a mouse.

"Shakespeare got it wrong when he said 'Neither a borrower nor a lender be,'" says Ross Levin, a financial planner in Edina, Minn. "The construction of debt is a powerful financial tool."

That said, it's crucial to remember how easily this tool can be misused.

Yes, home equity feels like a bottomless pot of gold, especially when home values are soaring, but it shouldn't be treated like found money. Your home itself is on the line; even if you never come close to defaulting, though, borrowing against home equity can have serious consequences.

Fortunately, if you borrow wisely, you can enjoy the extra cash without excess risk. With that in mind, what follows is everything you must know to understand the various methods of extracting equity from your home and to sort out which, if any, is right for you. Learn about cash-out refinancing, home-equity loans and lines of credit and reverse mortgages.

The mechanics of a cash-out refi are straightforward: When you refinance your primary mortgage, you borrow more than you currently owe on your home and pocket the difference.

The appeal, of course, is that in a low-interest-rate environment, homeowners often see little increase in their monthly outlay. If you convert a $200,000 loan at 6.5 percent into a $225,000 loan at 5.5 percent, for example, you'll bank $25,000 and see your monthly payment rise a mere $13.

That sounds great, but remember: You'll be stretching out the loan term, which means you'll ultimately pay more.

In the example above, if you refinanced five years into the original 30-year mortgage, you'd pay an extra $80,669 over the life of the loan. So don't blow the cash on frivolous items.

Jack Guttentag, a Wharton finance professor and mortgage expert, asks, "Do you want to be paying for that new car or vacation for the next 30 years?"

Used correctly, however, cash-out refis can be a powerful tool.

For Myrna and David Cunitz, 62 and 68, of Arvada, Colo., this kind of loan was the route to a far more comfortable retirement. Twelve years ago David had a stroke, and the couple's two-story house was ill-suited to a person with his new disabilities. David's wheelchair couldn't even fit into the kitchen.

"It was either move or do something with the house," says Myrna. New homes in the area were far too expensive. So they refinanced the $32,000 on their 15-year 6.5 percent mortgage into a $120,000 15-year loan at 4.34 percent, leaving them with cash to renovate and a manageable additional monthly payment of $150.

Paying off high-interest consumer debt is a popular -- but not always wise -- use of cash-out refis.

"Ultimately, you're just exchanging unsecured debt for the secured debt in your home -- and stretching out the payments over 30 years," says Bankrate.com senior analyst Greg McBride. And credit counselors say many who use equity to pay off credit-card debt just start abusing their plastic again.

But it can still be a smart move if you have a realistic plan and some discipline. Not only do you end up with a lower interest rate, but you also get a tax benefit: Mortgage interest -- unlike credit-card interest -- is deductible.

Last year Denver residents Kevin and Gail Remaley, both 42, were paying more than $1,000 a month to meet the minimum payments on their credit-card debt, never managing to chip away at the balance.

When they refinanced their 15-year mortgage in March, dropping the rate from 5.75 percent to 4.625 percent, they took out $40,000 worth of equity and used it to erase the credit-card debt. Though their mortgage payments are now $250 higher, they come out $750 ahead each month and don't pay credit-card interest rates.

"The way we see it, the slate is clean," says a relieved Kevin, who has created a new budget and is determined not to fall behind again.

If you think a cash-out refi makes sense for you, keep these points in mind:

• Don't do it just for the extra cash. The up-front costs -- typically about $2,000 -- are significant. So if refinancing doesn't make sense on its own merits, find a cheaper way to tap your equity (we discuss some below). Generally, you should consider refinancing if the new rate is at least three-quarters of a point below what you already pay.
• To avoid paying private mortgage insurance, don't borrow more than 80 percent of your home's value.

If refinancing doesn't make sense, you have two options to consider next: home-equity loans, which are made in a lump sum and have a fixed interest rate; and home-equity lines of credit, also known as HELOCs, which you can draw on in small chunks over a period of time and have variable interest rates.

Both have repayment terms of anywhere from five to 20 years, and the interest on at least the first $100,000 can be deducted from your taxes (unless you get hit by the alternative minimum tax, in which case the interest is deductible only if the loan goes toward home improvements).

And compared with first mortgages, both are easy and inexpensive to set up: Home-equity loans cost about $200, while lines of credit can sometimes be had with no up-front fee. HELOCs feature especially attractive rates: 4.5 percent on average, compared with 7.25 percent for a 10-year fixed loan.

Home renovations are the most common use for these loans. Richard and Linda Krieger, for example, of Oak Park, Mich., took out a $50,000 line of credit to redo their kitchen last year.

"It started with new furniture in the family room, and it looked so good we decided to do the kitchen too," says Linda. "I was tired of looking at those same lousy cabinets in the kitchen after 31 years."

The Kriegers used just $25,000 for remodeling. And though the current minimum payment is only $77 a month, they've wisely been paying as much as $700 a month with a goal of retiring the loan early.

Many Americans use their home equity to jump-start business ventures. We wouldn't recommend that everyone bet their primary residence on the success of a small business.

But for Miami residents Jen and Dinorah Yavitz, 32 and 40, it looked like a worthwhile gamble. Last fall Jen, who has run a drug-and-alcohol testing service out of his home for the past seven years, decided to buy and renovate a nearby building and use part of the extra space to expand his business.

Rather than taking out a commercial loan at 12 percent interest, he went with a $100,000 line of credit on his primary residence at 4.5 percent, which currently costs him $377 a month. Once the renovation is complete, Jen plans to rent out half the space for three times the amount of his HELOC payments -- and he figures it makes sense to keep the payments as low as possible until the renovation is done and the business is running.

"I wouldn't be able to rent an office space for under $400 a month," he notes.

Another clever use of these loans applies to those who have three years or less left on their primary mortgage.

If you haven't refinanced because the $2,000-plus cost outweighs the savings you'd recoup in just a few years, you may want to pay off your mortgage with a line of credit. You'll essentially be getting a very cheap, short-term refi.

So how do you decide between a loan and a line of credit? Here are some guidelines:

Go for a line of credit if you're not sure how much, or even if, you need to borrow. For continuing expenses -- say, helping a child with college bills -- a line of credit makes sense because you can take the money on an as-needed basis. An unused line of credit can also provide a safety net against a job loss or other emergency expenses.

That said, lines of credit are considered revolving debt by credit scoring companies. If you max out your line, you'll hurt your score. Loans, on the other hand, are considered installment debt and will help your score as long as you always pay on time.

Go for a line of credit if you can repay the loan in four years or less. Because the interest rate on the average line of credit is nearly three percentage points below the rate on the average loan, you should come out ahead with a line of credit even if rates rise by one percentage point each year -- and few experts think they'll go up much faster.

The converse, of course, is also true: Go with a home-equity loan if it will take you more than four years to repay.

Choose a home-equity loan if you might not be able to resist borrowing extra.

Let's face it: A line of credit that you can draw on anytime is pretty much a $25,000 wad of cash sitting in your desk drawer. You might find yourself blowing $3,000 of it on a wide-screen TV. And eager lenders have all but encouraged that kind of behavior. Some banks, including Wells Fargo, even offer a product that lets you draw on your HELOC at retailers using a charge card.

"Our experience is that customers are very self-conscious about using their home equity," says Doreen Woo Ho, the president of Wells Fargo's consumer credit group. Maybe. But do you really want that kind of temptation?

Here are a few more tips about home-equity loans and lines of credit:

• Shop around. Home-equity loans in particular tend to be offered at widely varying interest rates by different lenders; with a little searching, you can currently find a fixed-rate loan for under 6 percent -- not much higher than some HELOCs.
• With home-equity lines of credit, pay close attention to the terms. Some lenders tack on $50 to $100 in annual fees, and some charge early-termination and inactivity fees as well. And if you're planning to draw small amounts from a line of credit, watch for minimum-withdrawal fees.
• Be aware that interest rates on both lines and loans are more sensitive than rates on regular mortgages to credit scores. That can work in your favor -- if your credit is excellent, you may be able to get a line of credit without paperwork -- but if your score is below 700, you probably won't qualify for the best rates.

Reverse mortgages are complex, but here's the key point: In essence, they're home-equity loans that you don't have to pay back during your lifetime. (The principal and accrued interest are generally paid back by one's heirs using the proceeds of the sale of the home.)

You can take the cash in monthly payments or a lump sum, or draw on a line of credit. As for the interest rate, it fluctuates.

It's not surprising that the volume of reverse mortgages surged 76 percent last year. They hold obvious appeal for seniors who have built up a lot of equity in their homes but not enough cash for retirement.

The loans aren't based on credit history or income. The payments aren't taxed and don't affect Social Security or Medicare benefits (though they might disqualify someone from Medicaid). And the amount you owe can never exceed the value of the home.

But reverse mortgages can have serious drawbacks and should generally be used only if you've exhausted all other income options.

For one thing, the terms are so complex that it's difficult to comparison shop or determine whether you're getting a good deal. In fact, most are expensive. In addition to the usual mortgage closing costs, fees on a reverse mortgage can amount to 5 or 6 percent of a home's value.

On a $290,000 home in Maryland, for example, a typical reverse mortgage would cost about $14,000 to set up.

"This is definitely not something you should do to take care of a one-time medical bill or home repair," says Bronwyn Belling, a reverse-mortgage specialist at AARP. "We really encourage people to look at all the alternatives first."

But in the right situation, a reverse mortgage can make a lot of sense.

For Ken and Margaline Lindhal, 80 and 74, respectively, who live on Little Balboa Island in Newport Beach, Calif., a reverse mortgage enables them to maintain a comfortable lifestyle and stay in their house, which was built by Margaline's father and uncle in the 1930s.

Though the Lindhals get about $2,000 a month in income from Social Security and a small pension from Ken's previous job at Xerox, they had virtually no other retirement savings. Now the Lindhals can draw on a $405,000 loan against the cottage.

A few more points to keep in mind:

• Generally speaking, consider a reverse mortgage only if you're over 70. If you're in your sixties, the payments will be low, and you run the risk of outliving your equity.
• Consider downsizing first. Some seniors, like the Lindhals, feel very strongly about staying put. But others mistakenly assume that their home isn't worth enough to finance, say, a small condo in the area. If you or your parents have been in a home a long time, you might be surprised at its value -- so get it appraised.
• Make sure you understand the loan, including the fees. Reverse mortgages are complex. Fortunately, federal law requires reverse-mortgage applicants to get counseling before lenders can close the loan. If you're in the market for a reverse mortgage, your first step should be to talk to a HUD-approved counselor. You can get a list of counselors from AARP (888-687-2277; www.aarp.org/revmort).

What mortgage should you get? Type  What is it?  You'll want one if...  Who is it for?  30-year fixed  Payments are locked in for the life of the loan.  ...you're willing to pay for complete predictability. Interest rates are higher, but your payments won't change for the life of the loan.  Buyers who are likely to stay in the same house for at least seven years.  Adjustable rate  The interest rate is fixed for a set period, then fluctuates on a monthly or yearly basis.  ...you're willing to accept interest-rate risk in exchange for a lower rate and lower monthly payments. The shorter the fixed term, the lower the interest rate.  Buyers who are likely to move or refinance within a few years -- or are comfortable with interest-rate risk.  Interest only  You make only interest payments for a set period, then principal payments too.  ...you want to keep your payments down in the short term (at the expense of much higher payments later). Interest-only payments can reduce your monthly outlay by about 20 percent.  Buyers who are confident that their income will rise in the future.  Piggyback  Two mortgages (or a mortgage and a home-equity loan or line of credit) at the same time.  ...you don't want to cough up much cash for a down payment and also want to avoid private mortgage insurance (PMI). Some use piggyback loans to avoid jumbo mortgage rates.  Buyers whose PMI would cost more than the interest on the piggyback loan.

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