Educational Consumer Tips
Home Equity Loans
HOME EQUITY LOANS have become a new source of credit for thousands of homeowners who wish to finance the purchase of large, expensive items or pay off outstanding credit card debts, medical or educational expenses, home improvements or other expenses.
Home equity loans have become increasingly popular with taxpayers. One reason is the 1986 Tax Reform Act (TRA) according to CPA's. The Act gradually phases out deductions for non-mortgage consumer interest on credit cards, auto loans, and similar items, but preserves deductions for interest on some mortgage-related loans. Another reason is that the interest rates are generally lower.
Any loan that uses the accumulated equity in your home as security or collateral for the amount borrowed is a mortgage. Most home equity loans are second mortgages, whether you get a lump sum or a line of credit (a right to withdraw sums from time to time up to the credit limit established). Before deciding which form of credit suits your credit needs and interests, do not overlook the possibility of refinancing your existing home mortgage. Refinancing might permit a larger net loan, a lower interest cost, and a larger tax deduction.
By taking out a loan or establishing a line of credit based on your home equity (the market value of a house minus the amount owed on it), taxpayers may deduct the interest on loans up to $100,000 or the equity in their home, whichever is less. These provisions apply to taxable years beginning after December 31, 1987.
In 1987, only 65 percent of the interest on consumer non-mortgage loans was deductible. In 1988, only 40 percent was deductible. This figure dropped again to 20 percent in 1989 and 10 percent in 1990. Afterwards, no interest on consumer non-mortgage loans may be deducted at all.
Other advantages to home equity loans include a large credit line, reduced paperwork and payment flexibility. Since the loan can be structured as a line of credit secured through home equity, the borrower can continually tap into the loan, which is sometimes as high as $100,000 or more, to finance more than one expenditure, for example, a car and college tuition. Or the loan can be disbursed as a single, lump sum.
When the home equity loan is a line of credit, consumers can finance major purchases through checks or, in some cases, through credit cards. They also avoid the additional paperwork, delay and cost involved in taking out a new loan for each new purchase.
Interest rates lower than unsecured consumer credit are often another advantage of this new form of "credit." The loans are secured by consumers' homes, reducing the lending institution's risk. Actual interest rates on credit cards and unsecured personal loans may be significantly higher than those on home equity loans.
Additionally, the borrower is not always bound by fixed monthly payments. Although most lenders require and permit a minimum monthly payment of interest only, the borrower can usually repay as much of the loan principal as desired.
Choosing a home equity loan
While the tax advantages and flexibility of home equity loans make them attractive for some consumers, there are special costs and risks in opting for such a loan. Consumers should know the full costs and risks of their decisions and ask potential lending institutions a full range of questions about the terms of home equity loans before applying.
Following are some guidelines to help you decide whether a particular home equity loan is appropriate for you:
- Determine if your lending institution protects you against rising interest rates. Many home equity loans carry variable interest rates. These rates usually range one to three percent above the banking industry's prime rate, Treasury bill rates or various indexes, which often change weekly. Under new rules adopted by the Federal Reserve Board, however, lending institutions which offer home equity loans must set a maximum interest rate or a "cap" for the life of the loan. The amount of the cap will be up to the lender, but must be disclosed for all loan agreements signed on or after December 9, 1987.
- Compare the size of your lender's fee with that of other institutions. Origination and application fees on home equity loans vary considerably, are in addition to the interest charged, and are sometimes difficult to compare because you may not know what to ask. For example, some plans involve transaction fees charged every time you make a withdrawal against your line of credit, while others do not. Additionally, annual fees and other charges on home equity loans, including membership fees, appraisal fees, document inspection fees and other expenses charged by outside parties, are often not fully disclosed in advertising. Since these fees are not included in the annual percentage rate advertised by the lender, you have to consult the required Truth-In-Lending disclosure statement.
- Find out if your lender charges an inactivity fee. Borrowers who do not use their line of credit within one year or other time period may be charged an inactivity fee, which could be substantial.
- Be sure high annual fees and other costs do not outweigh the tax advantage of the home equity loan, especially if you are only borrowing a small amount. Lenders fix their application fees at anywhere from a few hundred to several thousand dollars. Others may have no fees or base their fees on a percentage of the total amount of the credit line. In either case, if you only use a small amount from the credit line, the fee may equal or outweigh any interest rate advantage or tax deduction.
- Be careful of interest-only payments on home equity loans. Institutions which allow borrowers to make only the interest payments on a loan for an indefinite period of time require borrowers to make a large "balloon" payment (the outstanding balance) on completion of the loan term. Refinancing that balloon payment instead of paying it off may require paying more new-loan fees.
- Find out whether your lender has the right to change the terms and conditions of your plan or terminate your plan. Most plans allow lenders these options under certain conditions. For example, a borrower with a questionable credit rating could have the credit line withdrawn causing the outstanding balance to be due immediately or over a set period of time.
- Be sure that all of the interest you hope to finally deduct on your home equity loan is, in fact, deductible. Remember, if you borrow more than $100,000 or the amount of equity in your home, whichever is less, you may not be able to deduct all the interest on your loan.
- Consider how you would handle future unexpected events. Faced with sudden financial instability, heavily indebted homeowners could find themselves defaulting on their loans and ultimately losing their homes. Try to have a contingency plan.
- Carefully evaluate your reasons for using the equity in your home for loans. Since their homes are at risk, most consumers use home equity loans or credit lines only for major, important purchases or financial needs. These include financing home improvements, large purchases, college tuition or medical expenses. Consumers with large mortgages, credit card bills, auto loans and other debts should exercise caution when utilizing their home equity loan. The flexibility of a large home equity credit line may tempt some to over-borrow or use the funds for smaller "frivolous" purchases. Some institutions impose a minimum withdrawal of $100 to $500 per check to help consumers avoid exploiting their credit line.
- Check the laws in your state. The laws which apply to home equity loans vary from state to state and are constantly changing. In addition, the sharp rise in the acquisition of home equity loans by taxpayers since the 1986 Tax Reform Act has caused many consumer groups and other organizations to call for modifications. For example, caps recently became mandatory on variable-rate home equity loans to protect consumers from the effects of a sudden sharp rise in interest rates. In the future, changes in the laws affecting payment terms and full disclosure of terms can be expected. An attorney, CPA or tax advisor can help you understand changes that may affect you.
- Know the full costs and risks of home equity loans before you make a commitment to a lending institution. Consider the fees and other costs that may outweigh the tax benefits and anticipate unexpected events such as loss of employment, higher interest rates or a large balloon payment. A CPA or other qualified financial advisor can help you manage your financial affairs so that you can reap the full benefits of a home equity loan.
Remember, for the vast majority of consumers, a home is their most valuable asset.
Questions and Comments
Question Submitted 2/26/2013I have a question about making the final payment on an equity loan, I called our bank asking what the final payment would be with interest which they did give a figure I was expecting with the exception of a $75.00 additional fee after payoff to clear our title. I can not find this anywhere in our original agreement but the bank is telling me it's a fee the the state of Massachesetts has and goes directly to the State, is this TRUE?
BBB's Answer:I am not sure if this is true or not. I would ask your bank to send you a document showing what the fee is and why it is required and ask them to provide the info on MA law that states that it is required.
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