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Make your house work for you
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May 21, 1999: 2:11 p.m. ET
Home equity loans can solve problems, but undisciplined spenders should beware
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NEW YORK (CNNfn) - "Jack," a resident of Scottsdale, Ariz., and a gold star customer of the credit card companies, was $60,000 in the hole.
The corporate executive, whose name has been kept confidential, tracked down a mortgage consultant, paid off the plastic with a 15-year home equity loan, and cut his monthly bills by $1,588.
"Jack's" case may be extreme, but Neill Fendly, vice president of the National Association of Mortgage Brokers, said it is by no means unique.
"I see countless numbers of people with credit card debt like that," he said.
Fendly, the consultant who got "Jack" back on his feet, said debt consolidation is the No. 1 reason consumers opt for home equity loans.
"We see borrowers with enormous amounts of credit card debt," he said. "We've had all these applications and pre-approvals thrown at us over the years and a lot of people took advantage of them. Many have $20,000 to $40,000 in credit card debt, and they're paying up to 19 percent interest."
If this scenario sounds familiar, financial experts say you may want to consider following in "Jack's" footsteps. By paying off the balance with a home equity loan, you could save yourself $1,500 to $2,000 a month.
"You can take $30,000 (in credit card debt) and put it in a 15-year low-interest equity loan and the payments on that are fairly inconsequential," Fendly said, adding a follow-up warning. "The only danger is that once that credit card is paid off, some customers can't resist the temptation to go out and use them again."
Once you pay off the cards, he said, cut them up and make a commitment to paying off your loan.
The dangers
Carmen Petote, a certified financial planner in Pittsburgh, Pa., said that's good advice. Before you look for an easy out to your credit card problems, he said, you should be perfectly clear on the risks.
"Everyone always talks about how great home equity loans are, but what people forget is that if they default on their credit card bills, all they have at risk is their credit rating, which is bad enough on its own," Petote said. "I'd much rather have that on the line than my house."
He added that home equity lines are not for everyone.
"If I can tell that clients are not responsible with debt, I will not recommend a home equity line," he said. "What happens very often is they use their home equity loan to pay off their debt, then they go out and run up their credit cards again and now they're twice as [deeply] in debt."
Loans and LOCs
Home equity loans and lines of credit have been the darling of debt consolidators for years, appealing to cash-strapped consumers with their combination of tax advantages and low interest rates.
In the last six months, however, the products increasingly have drawn the attention of a wide range of borrowers, including home renovators and parents looking to pay for their children's college education.
"Anytime you have interest rates rising on first mortgages, as they are now, you start to see more second mortgages, equity loans and lines of credit," Fendly said.
That's because homeowners who locked in a low interest rate on their first mortgage in the last few years are less willing now to use refinancing as a way to leverage equity. Instead, many take out a second mortgage or home equity loan.
The benefits
As far as tax breaks and interest rates are concerned, home equity loans and lines of credit are pretty similar. Both allow you to borrow against the portion of your home you already own.
Most banks limit the amount you can borrow on both products to around 75 percent of your existing equity. But, your equity includes not only what you've paid off to date, but the appreciated value of your home.
"The equity is based largely upon market value," said David M. Feldman, a certified financial planner in Parsippany, N.J. "If you bought a $250,000 home that now sells for $325,000, you've gained additional equity of $75,000. Part of that is what you will be able to borrow."
The biggest difference between the products is that home equity loans offer a fixed rate and establish a repayment schedule, typically over a 15-year period.
The line of credit, on the other hand, makes available to the borrower a certain pre-determined percentage of the equity in the home at interest rates usually in line with current market conditions. The bank issues the checks and leaves it up to the borrower to decide when and how to spend it.
As borrowers start dipping in, they get billed each month for a minimum monthly payment.
Interest
Equity loan products often come with much lower interest rates than first mortgages or unsecured loans, since the money you are borrowing is backed by your home.
Feldman said some lenders on the East Coast are even offering special home equity loans and LOCs at 7-1/4 percent, a quarter-point below the prime rate. He also noted that many lenders offering this type of financing will waive application fees, legal fees and closing costs in their race to win new customers.
Neither product assesses a penalty fee for paying back your loan early.
Do your homework, though. Those below-prime rate loans are sometimes teasers, introductory rates to lure you in. They often increase after the first six months.
It varies by region, but Fendly said most banks offering equity loans and LOCs today charge interest rates somewhere between 8.9 percent and 12 percent. By comparison, rates on personal lines of credit and credit cards can run well into the teens.
Write-offs
The added bonus with home equity products is that you get to deduct the interest paid, as you would with your primary mortgage. (This is true in most cases, but check with your tax adviser or the Internal Revenue Service to be sure.)
The combination of lower interest rates and tax deductions can significantly lower your effective interest rate. For example, if you take out a home equity loan for 6 percent, and you're in the 30 percent tax bracket, the net cost to you is about 4 percent a year, Petote said.
Uses and abuses
Aside from debt consolidation, one of the most common uses for home equity loans and LOCs is home improvement projects. For many consumers, this makes sense. Paying for renovations, which often cost thousands of dollars, by credit card not only saddles you with higher monthly bills, but it also takes away the benefit of deductibility.
"If the primary use of the monies borrowed from home equity loans is to improve your home then chances are, it's tax deductible," Feldman said. "It's the recommended route, without having to take out a far larger mortgage and strap oneself with larger mandatory payments."
Many homeowners also leverage their equity to help pay for their child's college education, especially higher income families that don't qualify for any other financial aid.
Red flags
If you're thinking about taking out a home equity loan, Petote said you should check your financial standing with a credit reporting agency well in advance. That way, if there is a mistake on the report or strike against you that you're unaware of, you'll have time to clean it up and still qualify for any special, or discounted rates.
"It can take you three months or more to do that, and these real low rates that banks are offering are usually only good for a certain period of time," he said.
Petote also added consumers should shop around for the best rates with a number of lenders. Find out what fees they charge, and steer clear of those that allow you to borrow 125 percent of the existing equity in your home, he said.
"That's a danger signal to say the least," he said. "Say you take out the loan and you want to move in two years to follow a good job opportunity. The value of your home will not have appreciated that much yet and you would still have to pay all that back. Your home becomes a prison."
His advice: Never borrow more than 80 percent of your home's equity.
In moderation
Feldman agrees, offering one final word of warning.
"I recommend to clients that [home equity loans and LOCs] be used on a select basis," he said. "Otherwise, you are spending all the equity that has appreciated in your home. If you are constantly borrowing against the equity, or increasing your equity line, there's nothing building."
--by staff writer Shelly K. Schwartz
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