How To Use Home Equity Loans
Danger!! Money borrowed from the equity in your home should be used to conserve, not consume! Unfortunately, you can see many home equity lines of credit darting across the lakes or on the mountain slopes.
The equity in your home is not like an ATM. The worst thing you can do is borrow against your home equity and buy depreciating assets. You borrow equity to conserve not consume.
Many newspaper ads offer home equity loans. Essentially, these loans are second mortgages in the form of a revolving credit line. They provide a method by which homeowners can tap the equity of their real estate. Often, homeowners can borrow as much as they need merely by writing a check. However, these loans can be dangerous. Variable interest rates with no upper limit, deceptively low interest-only payments and other complex schedules could easily put a borrower into a financial bind.
Why they are popular
The TRA ‘86 – or Tax Reform Act of 1986 – seems to encourage excessive use of home equity loans. A loophole as big as your house preserves interest deductions on home loans since the deductibility on interest on all forms of personal, consumer and student loans has now been phased out. Interest on home equity loans is fully deductible for educational or medical expenses. For other borrowing needs, including relatively frivolous ones like a vacation, home equity loan deductions are limited to interest on borrowing up to the original purchase price of the house, plus the cost of any improvements, and not the current appraised value.
The laws continue to change. You are entitled to take a deduction on your home’s “acquisition indebtedness” (or its lowest level) plus up to $100,000 of home improvements. The maximum deductibility (in 2006) is $1 million on acquisition indebtedness plus $100,000 of home improvements. Example: you buy a $400,000 home with a $300,000 mortgage and pay the mortgage down to $50,000 over time. The home value has grown to $600,000 and you want to refinance all the way up to $400,000. Careful! “Acquisition Indebtedness” is the original acquisition indebtedness mortgage or it’s lowest level. For this example, the lowest level is the $50,000 balance plus $100,000, so, the maximum you should be deducting on interest is a total of $150,000. After decades in the mortgage industry, I see these mistakes all the time. Contact me if you have questions.
New Property Advantages
Thus, some newer homebuyers can deduct more than equity-rich homeowners who paid comparatively little for their houses in pre-inflation days. This has started people thinking about selling the old homestead and buying a new one just to boost deductions. Real estate commissions, closing costs, and moving and redecorating, however, are likely to cost far more than one can save with a higher deductibility limit.
Multiple Sources
Home equity loans are now being heavily promoted by brokerage houses and finance companies as well as by banks. Such loans provide a line of credit that can go as high as 70 percent or 80 percent of the unmortgaged value of a house. Thus, if the house has an appraised value of $125,000 and you owe $50,000 on the mortgage, you might qualify for $60,000 of credit. (But remember, you might not be able to deduct all the interest on this amount).
Loan Features
You do not have to borrow it all at once, or any of it for that matter. The lender extends a special credit line to use as you please. The borrower pays no interest until he or she starts using the credit and then pays it only on the amount borrowed. The debt can be repaid at any time or paid off in installments over five to ten years, depending upon the lender’s terms. Another alternative is to pay strictly interest until the end of the term, and then pay off the lump sum left or refinance it.
Most home equity loan rates have no ceiling on how much they can rise from month to month over the life of the loan. The rate piggybacks on some index of market interest, usually the prime rate. The borrower pays the index plus one to three percentage points. If rates climb steeply, so do monthly payments. It is likely that interest rates will remain a volatile item as politicians continue to tinker with the economy.