How Home-Equity Loans and Lines of Credit Work
Home-equity loans and home-equity lines of credit have become an incredible engine not only of home ownership but of the consumer economy as a whole. Home-equity loans allow a borrower to use the equity in their home as collateral for cash they take out for a variety of purposes: home renovations, college tuition, car purchases, and sometimes other real estate investments.
Here's a brief definition of home equity. Let's say you paid $150,000 for your home twenty years ago, and you've paid off $50,000 of the loan. During that time, the market value of your home has also risen to $250,000. That means you have $150,000 in home equity (the $50,000 you've paid in plus the $100,000 in increased value) at your disposal.
You can tap that equity through either a home-equity loan or a home-equity line of credit. A home equity loan is a one-time, lump sum loan that is paid off over a particular amount of time with a fixed rate and number of payments. A home equity line of credit (HELOC), works more like a credit card because it has a revolving balance. Interest is due on the outstanding balance, and that rate may vary over time.
When investigating a HELOC, an adjustable-rate mortgage, home-equity loan, or any other form of mortgage-related credit, always ask the lender about the index upon which the rate is based. The London Interbank Offered Rate (LIBOR) consists of a series of benchmark interest rates for many of these products, as well as business loans and financial instruments — it's very common. Check the rate trends of your lender's chosen indexes over time.
In the old days, these were known as second mortgages because they are secured by the value of your home. And like mortgage interest, home-equity interest may be fully tax deductible in amounts under $100,000.
Your credit rating and amount borrowed factor into the rate you'll get on such a line. Most lenders advise you that your first and second mortgage shouldn't exceed 80 percent of your home's current fair market value.
The downside of home-equity debt is that many more homeowners who have used the lines to make major purchases and pay off debt have not been able to wean themselves from continued use of credit cards and other spending while doing so. Add that combination to rising rates, and you see an increasingly large group of homeowners facing the risk of foreclosure, being forced to sell or downsize, or, at best, staying in debt for years.
According to the Federal Reserve, in 2006, the median value of debt (including mortgage debt) in 2004 was $55,300, an increase of almost 34 percent from three years earlier. That increase stemmed largely from an increase in the value of mortgage debt secured by primary residence (mainly home-equity loans), which increased by 27.3 percent.
Consumers who access a home-equity line or take out a loan should avoid doing so unless their credit cards are paid off. If they use the line to pay those cards off, they should pledge to use them minimally from then on. If your purpose is debt consolidation, then wean yourself of revolving debt entirely.
If you or someone you know is already feeling the pinch of secured and unsecured debt at home, it's important to take a tough-love approach to changing your spending lifestyle and fixing the problem. Here are some critical steps:
Try to refinance outstanding debt into a low fixed-rate loan. If rates are heading up and you have a good credit rating and are planning to stay in your home for a while, make every attempt to combine your first and second mortgage into a fixed-rate first mortgage. Then you should attempt to pay a little more than the minimum balance each month.
Start by tracking spending. Whether you do it on computer or in a loose-leaf notebook, start tracking every dollar you spend. Computer-based tracking has the added benefit of making it easier to total up categories at tax time, but to get a handle on your finances, you need to know what you're spending first.
Then set a budget. It may mean cutting out the designer coffee and axing the premium cable channels, but once you find the flab in your everyday spending, take a scalpel to it. Evaluate everything nonessential in your spending, write down which categories you will cut back on, and divert those totals to paying more than the minimum on all outstanding debt.
Put away all but one emergency credit card. Redefine emergency away from snacks, carryout, and shopping sprees to car breakdowns and other critical spending that you don't have immediate cash available to cover.
Even though this is a book about mortgage financing, the way you handle the sum total of debt in your life will determine your ability to borrow successfully in the future.
