What You Should Know
About Home Equity Loans
Lynn O'Shaughnessy is the author of The Unofficial Guide to Investing (Macmillan, 1999). Her 612-page book covers scores of personal finance topics that include home equity loans, debt consolidation, selecting quality mutual funds, online investment tips, strategies for maximizing the new capital gains laws, investment club advice and more. While the book would appeal to beginners, it also provides plenty of information for experienced investors who already know the basics and want to learn more to boost their financial results.
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Home equity loans are hot. And if you haven't been approached to sign up for one, you probably will. On TV commercials, celebrities brag about all the cash you can pocket with just one easy toll-free call to a lender. In the mail, home owners will find plenty of offers as well. Tear open these envelopes and you'll often see fake checks written out for incredible amount of money. Act immediately, the letter urges, and you can redeem a real check for that whopping amount.
Of course, you should stop and wonder why lending institutions are so eager to thrust money in our faces. The answer is simple. The banks aren't really risking anything. Since you'll use your home as collateral, the banks may legally confiscate your house if you can't make the payments. For this reason, you have to consider the consequences very carefully before you make this move.
There are, however, plenty of reasons why home equity loans are enticing. For starters, the interest on home equity loans is still tax deductible. Let's say a couple, who is in the 28% tax bracket, paid $2,000 in interest payments in 1998. They could shrink their tax bill by $560. You won't get that same break on credit cards interest. But you should know that you can only take advantage of this tax deduction if you file a tax return that itemizes deductions.
With a home equity loan or a line of credit, you borrow against whatever equity you have in your house. Equity is the portion of the home that you actually own. For instance, if your house is worth $175,000 and there's a $100,000 balance on the mortgage, your equity is $75,000. Banks will often loan you 80% of your equity, which in this case would be $60,000. Some financial institutions will approve a loan that equals 100% of your equity and sometimes even 125% or 150%. It's unwise, however, to borrow more than your home is worth. If you do that, you could be paying on a loan for a decade or more and still not even own your front door.
The traditional home equity loan works like a traditional second mortgage. You borrow for a set number of years and the loan is usually offered at a fixed rate. You repay little by little every month for a preset number of years. Your other option is a home equity line of credit , which is sometimes referred to as a HELOC. This type of loan works a lot like a credit card. A bank will approve you for a certain amount of credit up to a ceiling. You don't have to use that money all at once or ever, but it's there if you need it. Let's say you have a $40,000 line of credit, but you only use $19,000 to pay off old credit card bills. You'll still be entitled to borrow the remaining $21,000 any time you want. As you repay what you owe, the amount available to borrow increases.
Home equity lines of credit are usually offered with variable interest rates. The rate will be tied to the prime rate-the rate the best corporate customers receive--or some other index. Lenders will often generate business by offering teaser rates--a ridiculously low rate that may vanish in six months. Make sure that you know what will happen to the interest rate after the introductory offer expires.
Historically, home equity loans were primarily used for sprucing up a residential property. Borrowers would take the money and replace a hideous kitchen or add a bedroom or two when the family outgrew their living space. But home equity loans can be used for many other purposes, including car loans and college tuition. But perhaps the most popular use of home equity loans today is debt consolidation. A study conducted by the American Community Bankers Association suggests that an amazing 40% of home equity loans are now being earmarked to pay off mountains of bills.
It's not hard to see way so many people are taking out these loans to wipe out their debt. The interest rate you obtain can be far lower than what credit cards charge. How much will that save you in the long run? Here's just one example from "Debt Consolidation 101," a booklet written by Gerri Detweiler, the author of "The Ultimate Credit Handbook." Let's suppose you owe $10,000 on credit cards that charge 19%. If you just pay the minimum every month, you'll ultimately write checks totaling an amazing $46,596. But what if you had instead obtained a home equity loan that charged 9%. If you paid off this loan in five years, you'd owe just $12,455.
Some soul searching is necessary, however, if you expect to use a home equity loan for debt consolidation. The loan can be a great tool to break free of the grip of plastic, but only if the borrower decides to stop overspending. If you use the money to pay off your credit cards, but you continue to charge the way you did in the old days, you may sink into even more serious financial trouble.
If you're interested in a home equity loan, be sure to shop around. The home equity market is extremely competitive. And don't just compare interest rates. Find out whether a lender will waive the cost of the appraisal and other charges for such things as credit and title reports. Also find out if you'll get hit with a yearly fee for your loan--many lenders charge $25 to $50. In addition, be sure to inquire whether the lender will charge you if you decide to terminate the loan after a year or so. Sometimes there is a stiff penalty of several hundred dollars.
If you do shop for home equity loans, watch out for unscrupulous mortgage lenders. They could try to entice you into signing papers for a high-cost loan that could ultimately become a financial nightmare. While you might not fall for these slick come-ons, perhaps your mom or dad or a grandparent would. These shady companies typically prey on homeowners who are elderly, as well as those who are experiencing credit problems.
In 1998, the Federal Trade Commission issued a consumer alert on these home equity scams. Here are some unethical practices to look for:
- Equity stripping. The lender issues a loan, based on the equity of your home, not on your ability to pay. If you can't make the payments you could lose the house.
- Loan flipping. You are urged to refinance over and over again. Each time you refinance, you pay extra fees and interest points which only increase your debt.
- Bait and switch. The lender offers you one set of loan terms when you apply and then pressures you to accept higher charges when you sign the final papers.
- Credit insurance packing: Some lenders will attempt to sneak in charges for credit insurance and other so-called benefits that you did not request. The lender hopes you don't notice this and just sign the loan papers.
- Mortgage servicing abuses. You never get accurate or complete account statements. That makes it almost impossible to determine how much you've paid or how much you still owe. You may pay more than you should.
What if you get cold feet shortly after you sign the loan papers? Don't worry. Federal credit law gives you three days to reconsider a signed credit agreement and cancel the deal without a penalty. (Sundays and legal holidays won't be counted.) You can pull out as long you are using your principal resident to secure the loan. The same right doesn't apply if you use a vacation or second home as collateral.
If you cancel the loan by the three-day deadline, you won't be liable for any amount, including finance charges. The lender must return any money paid toward the loan within 20 days.
Based in San Diego, O'Shaughnessy is a financial journalist, who writes for such publications as Mutual Funds Magazine, The Wall Street Journal, Bloomberg Personal, Better Homes & Gardens Family Money, Working Mother and Good Housekeeping.