If you need money to start your own business, meet college expenses or make some other worthy investment, your best source of cash may be right under your feet--the equity in your home.
But while borrowing against your equity can provide important tax deductions and low-cost financing, it's important to remember that you'll lose your house if you don't pay the money back.
"You're putting up serious collateral, so only do it for serious reasons," says Lawrence A. Krause, president of the San Francisco financial planning firm that bears his name. In addition to starting your own business or paying college costs, other good reasons to tap your equity include meeting major medical expenses or remodeling your house.
If you can justify borrowing against your equity, you'll have to sort through a host of loan products to find one that's right for you. They range from credit lines you can tap with a check to the relatively obscure reverse mortgage, with several others in between.
Here are your major choices:
- Home equity credit line. The most heavily promoted loan, it's basically a revolving line of credit usually equal to 70% or 80% of the equity in your property. You access the money by using a special credit card or checks linked to the account.
Lenders say you can't beat credit lines when it comes to ease of access, and they're great if you can use the money to pay off higher-interest credit card debt and retain important tax deductions for mortgage interest. Monthly payments are sometimes lower than those on charge accounts, in part because the money doesn't have to be paid back for several years.
But what lenders see as attributes, financial planners see as dangers.
"That easy access can turn into a curse if you don't have much discipline when it comes to spending, and the longer repayment schedule could cost you far more than a credit card loan you pay off more quickly," says Phil Kavesh, a partner in the Torrance-based financial planning and accounting firm Kavesh & Gau.
Many credit lines entail big start-up charges that raise the true cost of the loan, and maintenance fees can top $100 a year.
Most of the lines also have adjustable rates that can ratchet upward with inflation, and some must be repaid with a lump-sum balloon payment when the term of the loan expires. "If the balloon payment is due and you can't come up with the cash, you'll have to refinance or sell your house in order to pay off the loan," Kavesh says.
Still, credit lines are useful if you can control your spending. You might also want to set up a line if you don't have much "emergency money" tucked away to see you through the loss of your job or some other financial calamity.
- Conventional home equity loan. This is a no-frills second mortgage for those who don't like the uncertainty of variable-rate credit lines. You get the money in one lump sum, and typically pay it back at a fixed interest rate in fixed monthly installments.
Rates on fixed "seconds" are higher than rates on most adjustable credit lines--at least for now--but some borrowers feel that's a fair exchange for the security of locking in a set rate for the life of the loan.
Repayment schedules on seconds are usually longer than those for credit line loans, which also lowers your monthly payments. "And most are fully amortized, so you don't have to worry about coping with a balloon payment several years from now," Kavesh says.
Lenders will usually give you a home equity loan once you have a 20% or 30% equity stake in your property. Under tax code changes made last December, most homeowners can deduct interest charges on up to $100,000 of home equity borrowing, regardless of how the money is spent. The rule applies to both credit lines and conventional seconds.
If you borrow more than $100,000, you can deduct only the portion above $100,000 if it's used for home improvements. Generally, debt that doesn't qualify is treated as "personal debt," and only 40% of it can be deducted on your 1988 return.
- Home improvement loan. This kind of loan is usually taken out by a borrower who wants to fix the place up but has an equity stake of less than 20%.
Most lenders are willing to make home improvement loans to borrowers with small amounts of equity because they calculate what the property will be worth after the improvements are made. Since most remodeling jobs will raise the property's value, the lender figures that it will have adequate protection if it must eventually foreclose.
The big drawback to home improvement loans is that most lenders release the money in chunks. Each time the borrower asks for funds, the lender sends a representative out to the job site to check on the progress.
"I'd recommend taking out a straight home equity loan if you possibly can," says Tom Criser, a vice president with Van Nuys-based Valley Federal Savings & Loan Assn. "The cost is about the same, but you can get the home equity loan faster and with fewer hassles."