Making Sense of Home Equity Loans
A generation ago, home equity loans were often made by shady characters to the financially distressed. Today, second mortgages are a legitimate financial tool that can be of benefit to homeowners. They come in all shapes and sizes to meet the needs of various homeowners. Let’s examine their characteristics -- their pros and cons.
Second mortgages are increasingly popular today. Let’s be honest. Almost all of the A-paper borrowers in the country got a really cheap loan in 2002 or 2003, like 4% or 5% loans. If they need money for some good purpose, they are not going to want to refinance at current rates. It’s better to get a second mortgage.
There are two main types of seconds. The first is the Home Equity Loan and the other is the popular Home Equity Line of Credit, aka the HELOC, or “equityline” loan.
The typical home equity loan is distinguished from its popular counterpart, the equityline loan, in that the loan is for a fixed amount and the payment schedule amortizes the loan over a pre-set period of time. For example, if you borrow $50,000 at 7 percent for 15 years, the payment will be $449.41 per month and the loan will be paid off slowly over 15 years. Most lenders also offer a “30 due in 15” where the balance is amortized over 30 years. It has a balloon at the end of 15 years if you haven’t paid it off by then – hence the emphasis “due in 15.”
What makes home equity loans enticing and perhaps the most suitable is when their purpose is to finance a specific project, like re-modeling. These loans are widely available and you can get up to 90 percent of your home’s current value. But they are pricier. If your home is worth $500,000, you can borrow up to $450,000, so if your current mortgage is $300,000, you can borrow another $150,000.
You can also borrow what you need with a home improvement loan, one taken out to finance improvements to the property, like adding a recreation room or swimming pool or modernizing the kitchen. Such improvements add value to a property, so the lender will do an appraisal based upon the value after the improvement is completed and grant a loan on that increased value. I should warn you that the paperwork required on this kind of loan can be horrendous, but if you can’t get the loan amount you need based upon the current value of the home, this may be a good solution.
The negative of a home equity loan is that, once in place, it cannot be increased should some other need arise in the future. Let’s say you have such a loan and another need arises that requires a chunk of money. You can go get another home equity loan -- unless you made the mistake of getting your first one with a prepayment penalty.
A positive is that the loan is guaranteed to disappear over a period of time. Also, you do not have the temptation of drawing on it for some fleeting purpose as you can with an equityline loan.
As with HELOCs, discussed next, the market for these loans is highly competitive and there are precious few differences between them. That means the benefits of being a shrewd shopper are fewer as there are just not enough different options to choose from. The first stop should be to the loan officer or broker who helped you buy your home. All of us have numerous sources for these loans. Local banks are okay too, and existing customers will receive favorable treatment. Credit unions usually charge lower fees but you have to be a member. Finally, there are many Internet sources.
WARNING: Avoid prepayment penalties that lenders love to slip in when you aren’t looking.
While the interest paid on a home equity loan is tax deductible, remember that it is of benefit only to the extent that all of your deductions exceed the standard deduction available to all taxpayers. Also, there are some limits on deductibility of interest on loans over $100,000. Consult your tax advisor to see how the rules apply to you.
WARNING: I would advise against getting one of the heavily advertised 125 percent loans where the lender will lend you more than the equity in your home. Technically, they are not equity loans but “equity-destroying” loans.
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