If you need to borrow, a home equity loan usually offers the best rates, plus the advantage of tax savings.
Home equity loans let you borrow using the equity you’ve built up in your home as collateral. You can often borrow more money at a lower interest rate than with other types of loans. And, in many cases, you can deduct the interest you pay on the loan when you file your tax return, reducing the actual cost of borrowing still further. Most of the other interest you pay, on car loans or personal loans, for example, isn’t deductible.
You can choose between:
• Home equity loans, sometimes known as second mortgages
• Home equity lines of credit
Home Equity Loans
With a home equity loan, you borrow a lump sum, usually at a variable rate of interest, although some fixed-rate loans are available. You pay off the debt in installments, just as you repay your mortgage, with some of each payment going toward the interest you owe and the rest toward the principal, or loan amount. At the end of its term, or payment period, the loan is retired.
You may have to pay closing costs on your loan, just as you did for your first, or primary, mortgage. But lenders may offer loans with no up-front expenses as part of a promotional deal. You might also be offered a teaser rate, or a period of low interest, as an incentive to borrow. If that’s the case, the lender has to tell you the actual cost, or annual percentage rate (APR), and when the temporary rate ends.
Home Equity Lines of Credit
Home equity lines of credit are actually revolving credit arrangements, which you can use in much the same way you use a credit card. Your credit line, or limit, is fixed, and you can write a check for any amount up to that limit. Whatever you borrow reduces what’s available until you repay. Then you can use it again. The terms of repayment vary, and are spelled out in your agreement. In some cases you begin to repay principal and interest as soon as you borrow, or activate the line. In others, you pay interest only, with a balloon, or one-time full payment of principal due at some set date. Or, you may make interest-only payments for a specific period, and then begin to pay principal as well.
Most credit lines have an access period, often five to ten years, during which you can borrow, and a longer payback period. The longer you take to repay, the more expensive it is to borrow.
• They are easy to get
• The rates are usually lower than on unsecured loans
• The interest is tax deductible, though there may be a cap and other restrictions. Check with your tax adviser
What You Can Borrow
As a general rule, you can borrow up to 80% of your equity in your home with a home equity loan. For example, if you owed $75,000 on a home appraised at $250,000, your equity would be $175,000. In most cases, you’d be able to borrow up to $140,000, or 80% of $175,000.
Some home equity lines of credit, especially those offered without closing costs or other up-front expenses, are capped at a fixed amount, often $50,000. While you use the loan, your equity is
reduced by the amount you owe. When it’s paid off, your equity is restored. However, if your home loses some of its value during the loan period, you still owe the full amount you borrowed.
Beware the Risk
While home equity borrowing has many advantages, it has one serious drawback: If you default, or fall behind on repayment, you could lose your home through foreclosure. That means the lender takes over the property and sells it at auction. That’s true even if you’ve made all the payments on your first, or primary, mortgage.
That risk is the chief reason to be very cautious about using home equity borrowing—lines of credit in particular—to pay ordinary expenses. If you’re using the money to make improvements in your home, pay tuition bills, or meet other major expenses, and include loan repayment as a regular item in your budget, home equity borrowing can be a wise choice. But if you’re in the position of not being able to repay, you’re exposing yourself to losing everything you’ve invested in your home—and having no place to live.
• They can be very expensive when you consider total cost
• You risk losing your home if you default on the payments
• Even if the value of your house decreases, the amount of your loan stays the same
Finding a Loan
Home equity loans are generally available. Banks offer them, and so do credit unions, mortgage bankers, brokerage houses, and insurance companies.
You can start by checking rates and terms advertised in the newspaper and making some phone calls to see what’s available. But before you commit yourself, you should get a description—in writing—of the rates, the term, and the other conditions of the loan.
Setting the Rate
Each lender sets the terms and conditions of loans it makes, though the basic elements are usually similar. If the loan has a variable rate, it must be tied, or pegged, to a specific public index. The lender adds a margin, often several percentage points, to the index to determine the new rate each time it’s adjusted. It may happen once a year or sometimes more often.
For older people with lots of equity but limited income, a reverse mortgage may seem to be an appealing alternative to selling their home. A reverse mortgage allows owners to borrow against the value of their home, so that they can continue to live there. The loan does not have to be repaid until the home is no longer the borrower’s primary residence. However, the borrower must pay insurance premiums and real estate taxes to keep the loan in good standing.
You can apply for insured reverse mortgages through lenders who are approved to offer Home Equity Conversion Mortgages (HECMs) backed by the Federal Housing Administration (FHA) or from a limited number of other private lenders. The amount you can borrow depends on your home’s appraised value, the current interest rate, the age of the youngest borrower, and the amount of the initial mortgage insurance premium. In addition, FHA lenders impose caps on the amount they will lend.
While interest rates quoted on reverse mortgages can be similar to those for other mortgages, there are additional fees and charges that can make them more expensive than other types of loans. Lenders must provide a “Total Annual Loan Cost” disclosure that estimates the average annual cost as a percentage of the loan, and borrowers must be counseled by a HECM approved counselor. You can find a list at www.hud.gov or by calling 800-569-4287.
Regulations enacted in 2013 to protect both borrowers and the FHA require a financial assessment before a loan is approved and an escrow account in some cases. They also limit the amount that can be withdrawn in the first year of the loan.
Tapping your home’s equity to pay down debt or purchase things you couldn’t otherwise afford is usually a recipe for disaster, as many homeowners with large outstanding loans discovered during the financial crisis that began in 2008. If you need evidence that you should learn from other people’s mistakes, this is it.