HOMES  -  EQUITY LOANS
 
 

Home Equity Loans
 
 

Choosing a plan.   In choosing a plan to finance a large expenditure, consider which option best meets your long - and short-term needs. If you take out a second mortgage, you have to choose between a fixed-rate mortgage and a variable-rate mortgage. The fixed-rate mortgage is more expensive but is more predictable than a variable-rate mortgage.

The main drawback of a second mortgage is the burden of additional debt and often higher interest rates. If you are still paying a first mortgage, you may have difficulty with a second mortgage added. Nevertheless, the second mortgage might be a flexible method for financing large expenditures.

Big ticket items

A home equity line of credit is a convenient, flexible way to borrow that can preserve the deductibility of interest under the current tax laws. Once your line of credit is in place, you are not required to fill out a loan application again. But because such credit draws on the equity built up in your home (that is, the difference between the value of your home and what you owe on it), it should be used only for major expenditures and worthwhile purposes, such as home improvements, children's education expenses, major purchases (like an automobile), and, if you are committed to cleaning up your debt act, debt consolidation.

Rates fluctuate

Home equity-secured credit usually offers a lower interest rate than other lines of credit because it is secured by the equity in your home. Most home equity lines of credit have variable interest rates, which are usually based on the prime rate or a government Treasury bill rate index. This allows you to secure the best rate available at a given time. These rates will fluctuate over time, however, sometimes raising monthly payments. Make sure you can afford this flexibility.

Evaluate

When evaluating and selecting a home equity loan, review the following considerations:
 

• Is a home equity loan most suitable for your needs?

• What is the initial rate of interest? Is it fixed or variable? How often can the rate change? Is there a maximum cap on interest rates?

• Are there application fees? Annual fees? Closing fees?

• What is the minimum monthly payment? How much of it will go toward paying off principal?

• Do minimum monthly payments go up with variable interest rates? How much?

• Are there conditions under which monthly payments can be reduced?

• Can the bank demand refinancing of outstanding credit? Can any of the credit terms be changed without your approval?

• Is there an option to convert the line of credit into an installment loan with a specified term? If so, at what interest rate, and over what period of time?

• If your income or the amount of available equity increases, can your line of credit be increased?

Be cautious

Home equity loans can represent an excellent source of available credit. They are flexible, and the interest on them may continue to be tax deductible. But proper financing remains essential. It's all too easy to jeopardize your home as a result of abusing this relatively easy and heavily marketed form of credit. In essence, the proper management of home equity loans is no different from proper debt management of a mortgage. The loan principal should be paid off over a time period consistent with the use of loan proceeds.

Some lenders offer interest-only payments. This may be appropriate when special circumstances make it difficult or undesirable to pay down the principal. Generally, however, it is preferable to pay down at least some principal each month. In general, making only the minimum monthly payments on your home equity loan can be an early warning of potential credit problems.

Beware of balloon loans

With some plans, interest-only payments lead to a balloon payment at the end of the loan term. This arrangement may be appropriate for you if you can predict that you can pay off your loan at a future time (for example, if you are planning to sell the home). For others, it may be entirely inappropriate. In general, if you can repay your home equity borrowing over an appropriate period of time, it can be a very effective tool for credit management, despite the potential pitfalls.

Risks

Because the deductibility of consumer interest has been eliminated, home equity loans have become an attractive alternative for obtaining credit. Nevertheless, there are potential problems. If you fall behind on your payments, your home is at risk. Moreover, the variable interest rates on most home equity loans mean that if interest rates rise, payments will rise, too - perhaps dramatically. This is especially true of lines of credit with no cap on or maximum increase in the interest rate. In addition, although most home equity loans no longer charge points, many require fees. Finally, rules regarding home equity loan interest deductibility are complicated. The result: Home equity financing should not be seen as an easy and painless way to generate cash. The decision to convert home equity should be made only after a meticulous review of your options. An imprudent plan could be devastating.

Even people who manage their home equity credit lines reasonably well may find that, rather than entering their retirement years with little or no mortgage indebtedness (a very desirable financial planning objective), they are saddled with substantial mortgage payments well into their retirement years. Therefore, evaluate the long-term as well as the short-term implications of adding to your home indebtedness.