* Read this section if you have equity in your home - and you are interested in borrowing additional money.
Convenience and tax-deductible interest make tapping the equity in your home rather appealing. Just be careful that you don’t take a casual view about draining the equity in your home-- it could jeopardize your most important asset.
If you fail to make the loan payments, you could ultimately lose your home in a foreclosure.
Let’s proceed by discussing the different ways you can take money out of your home.
Home-Equity Loans
Home-equity loans, sometimes referred to as second mortgages, involve borrowing money and making principal and interest payments over a specified period of time. Here are some features of home-equity loans:
- Your repayment period can vary. However, lenders will generally not allow a repayment period of more than 15 years.
- You can generally borrow up to 75 to 80 percent of the current appraised value of your home, minus your outstanding mortgage balance.
HOT TIP!: You may find a lender that is willing to lend you more than 75 to 80 percent of the current appraised value of your home, minus the outstanding mortgage balance, especially if you can prove that you will be making improvements to the home that will increase its value.
- Interest rates are generally higher than on first mortgage loans.
- Lenders usually offer a choice between fixed-rate and adjustable-rate loans.
Home-Equity Line Of Credit
Another way to tap the equity in your home is with a home-equity line of credit. Instead of borrowing a fixed amount of money at one time, you can establish a line of credit against the equity in your home and draw on the money as you need it. The lender will set a limit on the total amount you can borrow and will issue you checks. It’s almost like a checking account, except you have to pay back the money! Following are some features of a home-equity credit line.
- The maximum credit line is typically limited to between 75 and 80 percent (but can be more depending on the lender) of the current appraised value of your home, minus your outstanding mortgage balance.
- Interest is usually a variable or adjustable rate that can vary as often as monthly.
CAUTION!: With most lines of credit as well as some equity loans, you will receive a variable interest rate. When evaluating these loans, make sure that you consider the worst possible scenario. In other words, be sure that you can handle higher monthly payments during a time of rising interest rates. Find out from your lender what the ceiling is. This is the maximum interest rate they can charge on your home-equity loan. Some can range as high as 16%-18% or even higher depending on where you live.
- You only pay interest on what you borrow, not on the entire line of credit.
- Lenders typically require a minimum monthly payment on any outstanding loan amount.
- Most home-equity credit lines are divided into two periods; a draw period and a payback period. A draw period -- the period of time you are able to draw from the credit line -- can last up to twenty years. The payback period is the period of time you have to pay back the outstanding balance. It usually ranges from ten to twenty years.
Loan Or Line Of Credit?
At first glance, it seems that a line of credit is the best way to go. It offers you flexibility-- you don’t have to saddle yourself with debt that you may not have a use for right away. You can draw down as you need the money and pay back accordingly. But, avoid the temptation to use your home-equity line as a source of ready cash for unnecessary spending. If you can’t control your spending, don’t take out a home-equity line.
Only you know yourself and your habits. We can’t stress enough that it’s dangerous to frivolously tap the equity in your home. After all, your home is likely the most valuable asset you own.
There is yet another alternative to tapping the equity in your home. Refinancing may allow you the opportunity not only to save money, but to borrow more of it.
Refinancing As A Source Of Funds
If current interest rates are lower than the rate on your mortgage loan, it may make sense for you to refinance as a way of tapping equity. You can borrow money in connection with a refinance when you have sufficient equity in your home. To find out if refinancing suits your situation, go through the following steps.
- Read the section titled "Refinancing Your Mortgage" first to get familiar with refinancing.
- In the section titled "Refinancing Your Mortgage" you will be able to see if refinancing makes financial sense in your situation.
- If you decide to refinance, the next step is to determine the maximum amount of additional cash that is available to take out. Read the section entitled "Appraisals", to get an idea of the dollar amount.
Reverse Mortgages*
* This section applies if you are at least age 62.
Probably the main reason that few elderly homeowners have taken advantage of reverse mortgages is that they have no idea what they are or that they even exist. Much like a home-equity line of credit, a reverse mortgage applies the same concept, but the money is not required to be paid back until the home is sold. This option allows cash-strapped elderly homeowners the opportunity to use some or all of the equity in their homes while they are alive. By doing this, they are able to live more comfortably and independently. Both government and private programs exist. Generally to qualify --
- You must be at least age 62.
- If you’re married, your spouse must also be at least age 62.
- You owe very little or nothing on your home.
- Applicants must agree to accept mortgage counseling from a federally approved counselor.
Once the reverse mortgage is in place, there are several different ways to tap into the money.
- Option #1: A line of credit is created and the funds can be drawn upon as needed.
- Option #2: A monthly payment is received by the borrower over a certain number of years.
- Option #3: A monthly payment is received by the borrower as long as the borrower occupies the home.
HOT TIP!: Whichever reverse mortgage option you choose, you can change options if your circumstances should change.
After the borrower moves or dies, the home is sold and the accumulated debt plus interest, and any other closing fees come due and are paid from the sale of the home.
In a nutshell, elderly homeowners who don’t have much of a retirement fund can live off the equity in their home while continuing to live in the home.
HOT TIP!: Contact the Federal National Mortgage Association (FNMA or Fannie Mae) for an information pamphlet on reverse mortgages and a list of FHA-insured lenders. You can obtain the phone number from 1-800 directory assistance.
What Makes Home-Equity Loans So Attractive?
It seems that every time you turn around, people are raving about their home-equity loans or credit lines. You pick up the newspaper and see countless ads by lenders advocating these loans and the great deals they have to offer you. Well, home-equity loans do have a lot to offer:
- Low cost. The fees associated with these loans are very reasonable. You can probably figure on costs ranging from about $800 or more depending on the amount of points involved. You may want to consider paying a point or more to get a lower interest rate (see the section "The Point of Points"). Keep in mind that many lenders allow you to add the costs to the loan, so you don’t have to come up with too much cash out-of-pocket. Some lenders may even offer "no-cost" refinancing, so it pays to shop around.
- Tax-deductible interest. Generally, interest on a home-equity loan or credit line is a tax-deductible expense. There are limits covered in our discussion on taxes later in this section.
- Easy to obtain. Your loan could be approved in as fast as one week. You always have three business days to back out of the loan after it has been approved.
Be aware that some lenders may check your credit record periodically to see if you’ve been responsible with your loans. They have the right to freeze or reduce your borrowing rights if they don’t like what they see on your credit report. Lenders also have the right to get a reappraisal on your home to make sure the equity in the home remains intact.
CAUTION!: Many home-equity loans and lines of credit offer low introductory ‘teaser’ rates. Many have strings attached to them such as annual fees and other hidden costs and restrictions. Make sure you find out all of the details first.
Popular Uses Of Funds
Many people use home-equity loans and credit lines to finance a variety of things. Because the interest is generally tax deductible, this very often makes sense. As you may already know, Uncle Sam has taken away almost all interest expense tax deductions. Exceptions include mortgage interest (including home-equity) and investment interest, and some student loan interest.
In this section, we will discuss the most popular reasons people use the equity in their home and try to help you sort out when it’s a good idea.
Home Improvements
Have you been thinking about putting an addition on your house? Or have you always wanted to finish the basement or add a bathroom? Using the equity in your home to finance its improvement makes a great deal of sense. After all, you are tapping the equity in your home to turn around and build more equity!
The types of improvements that you have always dreamed of can range in price from $100 to $1,000,000. When you use a home-equity loan or a refinance to make major capital improvements to your home, interest on a loan of up to a total balance of $1,000,000 is deductible. Make sure you borrow only what you can afford!
Automobile Purchases
Because auto loan interest rates are generally higher than mortgage rates, people often tap the equity in their homes to finance the purchase of an automobile. Sometimes the dealer that sells you the car may be offering a promotional financing rate. It would be wise to see how it compares to the rate on an equity loan or refinance. But, you can’t just compare interest rates, because there is a tax deduction for the interest on a home-equity loan or a refinance. Interest on an automobile loan is not tax deductible. The following illustration compares an auto loan and a home-equity loan with the same terms and shows the effect the deductibility of the home-equity interest has on the net annual cost of borrowing.
Auto Loan Versus Home-Equity Loan Comparison *
|
Auto Loan |
Home-Equity Loan |
| a) Interest Rate |
6.50% |
6.50% |
| b) Amount Borrowed |
$15,000 |
$15,000 |
| c) Annual Interest Charged: Multiply (a) times (b) |
$975 |
$975 |
| d) Marginal Tax Rate |
N/A |
25.00% |
| e) Tax Deduction: Multiply (c) by (d) |
$0 |
$244 |
| f) Net Annual Cost of Borrowing: Subtract (e) from (c) |
$975 |
$731 |
* Assumes a 25 percent marginal tax rate and the same repayment period for both types of loans. Also assumes that there are no fees charged for either loan.
As you can see from the illustration above, the cost of borrowing is generally less with a home-equity loan than an auto loan since the home-equity interest is tax deductible. However, it may not be wise for you to tap the equity in your home to buy a fancy car that you really can’t afford. Also, don’t overextend the debt on your most important asset. You have to feel comfortable with the fact that you are borrowing against your home and that there is a risk that it could be taken away from you if you cannot keep up the loan payments. Also, keep in mind that you may be paying on your home-equity loan for 15 years. You may be making payments on an automobile that you have long since sold. This is not good! A rule of thumb is that you shouldn’t stretch any loan, including a home-equity loan, past 5 years for the purchase of a car.
Consolidation Of Debts
Do you cringe every time you open the mailbox and another credit card bill arrives? Do you have a wide array of debt that is strapping you? Tapping the equity in your home to pay off your high-interest consumer debt may be something that you should consider. By doing this you can accomplish several things.
- Lower the cost of the debt. Almost universally, home-equity loan and refinance rates are much lower than the interest rates on credit cards, auto loans and maybe even your student loan. You can save money on the compounding interest by paying them all off with an equity loan; you will shift the borrowed money into a lower interest rate. Also, the interest on a home-equity loan of up to $100,000 is tax deductible no matter what you use the loan proceeds for. See the section "What Can You Deduct on Your Tax Return".
- Improve your cash flow. If you are paying less for the borrowed money, you can pay it back faster and use the remaining money for your other needs or investments.
- You only have to keep track of one loan. This can make it easier for you to manage your spending -- by knowing exactly how much you are in debt. It will also save you money in check writing and stamps!
CAUTION!: Home-equity terms can stretch to as many as 15 years. In order to keep your monthly payment low, your temptation may be to go for the longer term. Your best bet when refinancing consumer debt is to limit your loan term to a maximum of 5 years.
College Tuition
What do you do when your child gets accepted to an expensive school and you really want them to attend? You didn’t anticipate the cost when you planned a college fund. A home-equity line of credit can be set up in advance, and you can borrow what you need each year for the expenses.
CAUTION!: Equity in your home is not counted as an asset when applying for financial aid. Therefore, you should wait until your financial aid application is accepted or denied before tapping into the line of credit.
The Process
Now that you are more knowledgeable about the workings of an equity loan and you are ready to begin evaluating them, there are steps that you should take in order to make the process a smooth one.
The process consists of:
- Gathering information from potential lenders regarding rates, fees and loan types and
- Determining which loan makes the most financial sense for you.
To evaluate which loan makes the most financial sense you’ll need to:
- Compare the loan fees and costs among your different loan choices.
- Evaluate if you should pay points -- see the section "The Point of Points" and do a rate versus point comparison.
- Determine if the interest is tax deductible. See the section "What You Can Deduct on Your Tax Return".
- Determine the after-tax cost of borrowing. If the interest is tax deductible, it reduces the net cost of borrowing. See the section "Total Cost of Borrowing".
HOT TIP!: Shop for the best deal. Getting a good interest rate with a minimum of closing costs is your first objective. Choose the loan with the lowest overall cost of borrowing.
Procedures Checklist
You’ve decided to apply for an equity loan. Here are the procedures you need to follow:
- Fill out an application.
- Ask your lender if fees can be included in the loan amount.
- Get an appraisal.
- Determine what is tax deductible.
We will walk through each of these procedures in detail in the following sections.
The Application Process
After you find a lender that has a package that makes financial sense, it’s time to apply for the loan. The application fee can range anywhere from about $150 to $450. Some lenders may even offer deals to refund the fee once the loan is closed. In most cases, the fee is not refundable, so don’t submit the application until you are reasonably certain this is the lender you want. It’s also a good idea to get pre-qualified for the loan. Ask the lender before submitting the application if there is a pre-qualification program. The loan officer will tell you what you need to do to get this done; it could save you a hassle once you have submitted your application with the fee.
If you choose to get a home-equity loan with your current lender because they can give you the best deal, you could save money on the fees. And, the process can be smoother since the lender already has information about you. You also may not need to get a new appraisal on your home when you apply for a home-equity loan with your current lender. However, this could be a rare occurrence in these days of fluctuating real estate values.
A full-blown credit history is not usually required to obtain a home-equity loan. The lender will usually just check your existing credit file and do a simplified income verification. It is important that your mortgage payment record be in good shape.
Fees
Did you know that you may be able to include most if not all costs of obtaining a home-equity loan in the new loan? Each lender has its own rules, so be sure to ask your lender how it handles the fees. Including the costs in the loan makes it that much easier to go through the process because you won’t be required to come up with a lot of out-of-pocket cash. The most significant cost that you can include in the loan amount is the points. Instead of paying them outright, you can finance them with the principal amount. Just remember, there’s no such thing as a free lunch! Taking out a bigger loan will mean higher monthly payments.
Thanks to bank regulators, lenders must provide people who take out a home equity loan with a reasonable estimate of settlement costs and fees associated with the loan, this is called a "Good Faith Estimate". They must do this within three business days after receiving your application.
Appraisals
As the name home-equity loan suggests, you must have sufficient equity in your home before you can tap into it! As we said earlier, lenders are not usually willing to lend you more than 75 to 80 percent of the value of your property (some lenders may lend you more than that depending on their lending policies, so it's a good idea to shop around), minus your outstanding mortgage balance. Here’s an example.
Let’s say your home recently appraised for $155,000. Your mortgage balance is $109,000. You could qualify to take out an equity loan or line of credit of approximately $7,250.
| Value of the home |
$155,000 |
| 75% of the value |
$116,250 |
| Minus: Principal balance remaining |
-109,000 |
| Amount you can borrow |
$7,250 |
If your home happens to appraise lower than you expect, you may have to wait for the real estate market to improve and your mortgage principal balance to decrease (through your mortgage payments) before being able to get the amount of money you need.
What Can You Deduct On Your Tax Return?
There are some special tax rules with regard to what costs can be deducted in connection with an equity loan or credit line. Let’s see what tax breaks you’ll get from Uncle Sam.
Interest
The beauty of home-equity loans and lines of credit is that the interest, on debt up to $100,000, is tax deductible no matter what you use the money for.
CAUTION!: If you are married filing separately, the limit is reduced to $50,000.
If you borrow against the equity in your home to make major capital improvements to the home, the interest on up to $1,000,000 of debt (counting both your existing first mortgage and the home-equity loan) is tax deductible.
CAUTION!: If you are married filing separately, the limit is reduced to $500,000.
Points
There are two different ways that the IRS treats home-equity points.
- If you are borrowing to make capital improvements to your home, the points are fully deductible in the year you borrow. Now, this gets tricky if only a portion of the loan is used for the improvements. If this is the case, only the portion of the points related to the improvements is deductible in the year you borrow. The remaining points are required to be deducted equally each year over the term of the loan or the line of credit.
- If you are borrowing for any other reason, the points must be deducted equally each year over the term of the loan or the line of credit.
- If you pay off your loan early, the points become deductible immediately.
This information should serve as a guide for you--to give you an idea of what’s tax deductible and what’s not. You should call your tax advisor to clarify anything you don’t understand and to verify that the information is still valid under current law. Keep in mind that tax laws are always subject to change, and that the information provided here could change at any time, so don’t take it for granted!
