Many homeowners don’t have just one mortgage, they have two. Second mortgages, more popularly known as equity loans, provide a way for homeowners to finance just about anything, from kitchen remodeling to braces for their children.
About 9 million households, or 13 percent of all homeowners, had home equity debt in 1997, up from 11 percent in 1988, according to the Survey Research Center at the University of Michigan.
Equity loans are popular because the interest charges are tax-deductible, just as interest is deductible on first mortgages. Interest on other types of consumer debt, including auto loans and credit cards, cannot be used as a tax deduction.
Not only is interest deductible, but the rate on equity loans is often lower than on other types of loans. In short, using a home equity loan is often touted as a “smart” way to borrow in lenders’ advertisements.
Personal finance experts agree that tapping equity can be a prudent way to finance a home improvement or to foot college tuition bills. However, they stress that it’s only “smart” to borrow on equity if consumers really understand these loans.
So, here’s a primer on today’s most alluring debt vehicle:
When a homeowner takes out a home equity loan, it means he’s borrowing money using the part of his home he actually owns–his equity–as collateral. If, for example, your home has an appraised value of $100,000, and your mortgage balance is $75,000, your equity is $25,000.
Although the term “equity loan” is often used generically, equity credit actually comes in two basic varieties: loans and lines. The key difference is that with an “equity line,” you draw funds as you need them, up to a specified credit limit. And you pay back only interest until the line of credit expires and the balance is due, often in 10 or 15 years.
With an “equity loan,” you’ll receive one lump sum upfront, and pay back both principal and interest in regular monthly installments. Ten- or 15-year terms are also common with equity loans, notes Jim Anderson, a loan officer with Koenig & Strey Mortgage, Winnetka.
The interest rate that a lender will charge a particular borrower is based on three factors, says Ken Perlmutter, president of Perl Mortgage, Chicago. The most important criterion is the borrower’s credit rating, followed by the proportion of equity he wants to borrow on. The third factor is the size of the loan; a borrower can sometimes win a rate reduction if it’s $100,000 or more.
In the example outlined above, where the owner has $25,000 in equity, if a lender advanced the entire $25,000 in an equity loan, it’s called a 100 percent CLTV, meaning “combined loan to value.” Generally, the higher the CLTV, the higher the interest rate a lender will charge.
“You’ll receive the best rates if your CLTV is less than 80 percent,” says Saundra Schrock, chief executive officer of Bank One’s consumer lending division.
The very low advertised rates on home equity, such as 1 percent below prime, are reserved for borrowers with good credit, a low CLTV, and requests for jumbo amounts, such as $100,000, says Perlmutter.
You’ll want to shop a few lenders to find the best rate. In addition, some lenders won’t charge closing costs on an equity line or loan, including the costs for processing the paperwork and getting an appraisal, if the lender requires one.
“You look for a combination of the lowest interest rate and the lowest closing costs,” notes Anderson.
As important as it is to secure a competitively priced equity loan, personal finance experts applaud consumers more for how they spend loan proceeds than for which type of loan or rate they obtain.
If you’re using equity credit to pay for everyday expenses such as groceries, or, at the other end of the spectrum, for luxuries such as vacations, it’s a sure symptom of reckless overspending, says Cate Williams, president of Consumer Credit Counseling of Greater Chicago.
One of the more controversial uses of equity loans is to consolidate debt on credit cards. Lenders often pitch debt consolidation in equity loan advertisements, urging consumers to get “one easy payment each month.”
Even though, on paper, it makes sense to switch high-interest credit card debt for lower-rate, tax-deductible equity interest, in reality most consumers get into deeper debt with this approach, says Williams. That’s because after consolidating credit card debt into an equity loan, they begin charging anew on their credit cards. The debt consolidation concept works only for those borrowers disciplined enough to abandon credit card use.
Using home equity proceeds to pay for home improvements or college tuition bills are considered smart uses by most personal finance experts.
After a student takes out his own federally guaranteed loans, the most economical financing for most parents is home equity debt, notes Raymond Loewe, president of College Money, Marlton, N.J. However, Loewe points out that parents with incomes under certain limits may qualify for federal “Parent Loans for Undergraduate Students,” whereby interest charges are also tax deductible.
Loewe also warns parents against taking on a large amount of equity debt to pay for their child’s college if they also plan on retiring in the near future.
“What happens is that some people discover they just can’t live on their pension and pay their mortgages too,” he says.
Home improvements, which usually boost a home’s value, are probably the most logical use of home equity. Studies show that people do more home improvements during the first two years after they’ve bought than they do all of the next 10 years that they are in the home, says Walter Stoeppelwerth, president of HomeTech Information Systems in Bethesda, Md. Many lenders now offer home buyers an equity line of credit right away when they close on their home.
And while some buyers may immediately open a line of credit when they purchase, in some instances people use an equity loan to buy a house.
In situations in which home buyers are making less than a 20 percent down payment, it may be more economical to fund a home purchase with a combination of an equity loan and a mortgage, rather than one larger mortgage, notes Reed Brunzell, a loan consultant at Hartford Financial Services, Skokie.
“What happens is you get a mortgage for 80 percent of the purchase price, you get an equity loan for 10 percent or 15 percent or the price, and you put down 10 percent or just 5 percent of the price as a down payment,” says Brunzell. “Normally, whenever you put down less than a 20 percent down payment, you have to pay for private mortgage insurance.”
Perlmutter agrees that using a combination of an equity loan and a mortgage can save costly mortgage insurance charges each month.
“My clients save anywhere from $70 to $100 a month,” he notes.
Just as first mortgages can be refinanced, so can an equity loan or line.
“If you see a better rate advertised, you simply go to the lender and apply,” says Anderson. If your application is approved, the new lender advances enough to pay off the former equity line or loan.
When someone is seeking an equity loan or line, Anderson also advises checking to see that it does not carry any prepayment penalty. That’s because you won’t want to incur a fee if you decide to pay off the loan early.
