Home Equity Loans: A Blessing or a Curse?
Liz Gorham, Ph.D., AFC
Family Resource Management Specialist
Utah State University Extension
Are home equity loans a blessing or a curse? The dilemma raised by this question merits discussion. Does the benefit of being able to take out a tax-deductible low interest loan outweigh putting your home in jeopardy of foreclosure if you are unable to pay back the loan as agreed in the contract? Jane Bryant Quinn, noted family finance practitioner and author, suggests that there are appropriate and inappropriate times to borrow against your house.
USE A HOME EQUITY LOAN:
* To consolidate or pay off expensive credit card debt
* For major investments (i.e., education, home improvements, buying investments that yield more than the cost of the loan)
* If you anticipate that you can comfortably handle payments and have a backup planfor unanticipated drops in your income
* If you have the discipline needed to make regular payments.
DO NOT USE A HOME EQUITY LOAN:
* To support your consumer spending habit or for day-to-day expenses
* If you think of the loan as a permanent debt, not to be repaid until you sell the house
* If you will soon need the home equity to pay for college or some other major purchase
* If home values in your area are going down and/or you anticipate losing or decreasing your income
What is a home equity loan? A home equity loan (or HEL) is, in essence, a second mortgage on your home. If you default on the payments, the lender can foreclose on your home. Like a lender who repossesses your car if you miss payments, you could also lose your home. On the other hand, a home equity loan can be a powerful financial tool if used properly. In an example provided by Steve Tyler of Best Mortgage Company, you could save $1,000 per year in interest on a $20,000 debt by paying a lower rate of interest (10% instead of an average of 15%) on a home equity loan. You can qualify for a lower rate of interest on a home equity loan than the rate of interest charged on most credit cards and installment loans due to the added security of using your home as collateral. In addition, the interest paid would be tax-deductible, the amount dependent on your income tax bracket (the higher the tax bracket, the greater the savings).
What factors should be considered before signing up for a home equity loan? Jean Lown, Professor of Family Finance at Utah State University, warns that using a home equity loan to finance depreciating assets, vacations, or other ventures which do not build net worth or human capital is risky. The home is the largest asset for most families which is an important resource for providing financial security in retirement. Risking foreclosure on the home, is a high price to pay in an attempt to save taxes.
Check for the following financial traps listed by Consumers Union (CU):
* Up-front point charges and other closing costs that are out of proportion to the amount actually borrowed
* Variable interest rates with no limit on how high rates can go (lifetime rate caps now required but, at 18 to 20%!)
* Advertised low initial rates that vanish quickly
* Long payback periods, leading to large interest charges over the years
* Eventual lump-sum balloon payments that may be hard to meet
* Temptation to spend frivolously
* The risk of losing one's house
How much can you borrow? Some lenders allow you to borrow up to 100% of your equity in the home but many still limit you to a total combined Loan-to-Value (LTV) ratio of 80%. This means that an owner with a home valued at $100,000 and a first mortgage of $60,000 could borrow up to $20,000 ($100,000 X 0.80 = $80,000; $80,000 - $60,000 = $20,000). The maximum loan amount possible will be capped at $100,000. Most lenders will consider your ability to repay by looking at your income, debts and other financial obligations, as well as your credit history and that of any co-borrower when deciding the LTV ratio they will allow. Lenders making loans without a credit check do you no favor; they may, instead, be plunging you into ill-advised debt.
How much should you borrow? Consider the security of your employment, your current debt-to-income ratio, funds in your savings account, and the face amount and provisions of your disability and life insurance policies. Temporary or permanent loss or decrease in income can mean failure to pay debts owed and eventual home foreclosure. Will the real estate you own appreciate or will values fall? If values fall, owners can find themselves owing more than the home is worth.
There are two basic types of home equity loans.
1. Fixed Home Equity Loan - known as a traditional second mortgage loan, it is a one-time lump-sum loan for a fixed amount with a fixed payment schedule, usually over 15 years with your home serving as collateral.
2. Home Equity Line of Credit - an open-ended line of credit that operates like most credit cards with your home serving as collateral. Once approved for the home equity line of credit, you will usually be able to borrow up to your credit limit whenever you want. However, be aware that there may be limitations on how you use the line. For example, some lenders may require you to borrow a minimum amount each time you draw on the line or keep a minimum amount outstanding. Some lenders may require you to take an initial minimum advance when you first set up the line. You are able to access your account (by check or credit card) to borrow different amounts at different times up to your maximum credit limit. You pay a variable rate of interest (indexed to the prime lending rate published in the Wall Street Journal). The charge is usually much less than most credit cards. Often there is a fixed time limit (i.e., 10 years) during which you can draw money down. At the end of the contracted period, you may be allowed to renew the credit line. If the plan does not allow for renewal of the line of credit, you will not be able to borrow additional money once the time has expired. Some contracts may call for payment in full of any outstanding balance, while others may permit you to repay over a fixed period of time.
Which type of home equity loan best suits your needs? If you are borrowing for a single purpose, are on a limited budget, and/or need the discipline of regular fixed payments, then stick with the traditional second mortgage. If you need flexibility (the option to borrow more without rewriting the loan and incurring new mortgage closing costs) to meet a series of needs at different time intervals and have enough discretionary income to be able to accommodate a varied interest rate, then try a home equity line of credit. Compare total costs of the two types of loans, including annual percentage interest rate (APR) as well as fees and charges. It is, however, impossible to compare just the APR for a traditional second mortgage with the APR for a home equity line of credit because the APRs are figured differently. The APR for the fixed loan takes into account the interest rate charged plus points and other finance charges. The APR for the home equity credit line is based on the periodic interest rate alone.
Where do you get a home equity loan? Home equity loans are being aggressively promoted by banks, credit unions, savings and loans, finance companies, and some large brokerage houses. Investigate at least three sources when shopping for any home equity loan. Compare interest rates and fees. Interest rates are fixed or variable. Some may have the option of converting a variable rate to a fixed rate during the life of the loan. Many of the costs of setting up a home equity loan are similar to those paid when you buy a home such as fees for loan application, property appraisal, points (one point equals 1% of the credit limit), membership or maintenance, transaction, attorneys, title search, mortgage preparation and filing, property and title insurance, and taxes. It is, however, a simpler application process than for a first mortgage. These closing fees typically range from $99 to $500 (Signet). In many cases, the financial institution setting up the home equity loan will roll the closing fees into your fixed loan amount or allow you to pay for them as the first draw on your line of credit.
What should you bring with you to apply for a home equity loan? According to Charter National, you will need the following: copy of your most recent pay stub, a copy of your 1040 income tax returns for the last two years, a copy of the receipt for property taxes paid on your home, a copy of the deed to your home, first mortgage information (if applicable, the account number, the lender's name and address, and balance owing).
What law regulates home equity loans? The Truth in Lending Act requires lenders to disclose the APR, miscellaneous charges, payment terms, and information about any variable-rate features. Such disclosures are made available to you at the time of application and prior to loan closure. Under this law, you are given three days from the day your home equity account is opened to cancel the loan for any reason. The creditor is obligated to cancel the security interest in your home and return all fees paid in opening the account.
Is a home equity loan for you? Perhaps home equity sales promotions and contracts need a disclaimer that reads: "This HEL could be dangerous to your financial health and security." Use the information contained in this article and proceed with caution. Base your decision on your long-range financial plan. If, after you have done your homework, you decide that a home equity loan is for you, use it carefully to improve your financial health and security. However, if you have major doubts about your ability to repay the home equity loan, consider other alternatives (sources of extra income or cutting back on your spending) for financing your needs.
Charter National home equity information.
Consumers Union. (1986, November). Should you hock your home? Consumer Reports, 739-743.
Ellis, J. (Ed.). (1990). It's time to rethink your biggest investment. In Smart money moves for the 90's, p. 73, 75.
Lown, J. (1987). Home equity conversion: A counseling model, Journal of Home Economics, 80(4), 6-10.
Quinn, J.B. (1991). Making the most of your money. New York, NY: Simon & Schuster.
Tyler, S. (1994, December). Cash from HEL.