Home Equity Loan - A Smart Move?
Your home equity can help in an emergency
Been looking twice at those offers for a home equity loan to consolidate your debt? Paying off high-interest credit-card debt with a home equity loan can help financially troubled families. And in some cases the interest on a home equity loan may help reduce income tax liability. Home equity loans are certainly popular. The Controller of the Currency reports that outstanding consumer debt has doubled since 2002 and now exceeds $1.1 trillion.
Although consolidating debt always sounds like a good idea, it may not be ideal for your situation. Consumers who take out home equity loans to consolidate credit-card debt often run up their cards again. One study showed that 70 percent of households using equity loans to consolidate debt had new credit-card balances at the end of a year.
However, for many home equity loans are a useful financial tool. As with all tools these loans must be used carefully or financial injury may occur. Used for sound money management purposes, such as buying a car or the financing a college education, equity loans make good sense.
A study by the Consumer Bankers Association published in November, 2006 found that the average home equity borrower has a FICO credit score of 730, a household income of almost $90,000, a home worth $337,000, and an existing first mortgage of $169,000. The average new equity credit line taken out that year was $84,812, while the average home equity loan or second mortgage was $57,800.
Home equity loans are made in two ways. The first choice is a fixed term, fixed interest rate and fixed amount loan that is similar to an automobile loan. Typically, these types of mortgages are made for periods of 5 to 20 years. Each payment is the same, and the loan is paid off at the end of the term. Fixed rate loans are the least risky equity loan since your interest rate is fixed and you will have a zero balance at the end.
The second alternative is a line of credit secured by your house. The line of credit can increase and decrease just as a credit card balance does. The monthly payment is usually based on 1.5 percent to 2.5 percent of the outstanding balance. As with a credit card, this balance can go on almost indefinitely if the borrower pays the interest and a little of the loan principal each month.
These loans can be risky for all but the savviest borrowers. Many lenders will end the line of credit after 10 years and require that the balance be paid off over the next 10 years. As a result, your payment will increase greatly during the second ten years.
Another risk with lines of credit is that their interest rates are adjustable. So in a time of rising interest rates, you will pay more interest every time the prime rate increases and your payments could easily double over time. This can be dangerous for those on a tight budget.
Finally, the tax deductibility of home equity loan interest sounds enticing but may not always benefit typical borrowers. For many homeowners, the standard deduction would exceed any benefit gained from itemizing interest expense.
Gary Crum is a nationally published author with more than twenty- five years in the mortgage banking business. He holds a BSBA from Florida State University and an MBA from Florida Atlantic University.