Still, there’s some unease about using your house as the ultimate in credit cards. Even though home-equity lines of credit are selling like gangbusters-up 17 percent last year, reports SMR Research in Budd Lake, N.J.-a majority of borrowers prefer the plain-vanilla fixed-rate loan-especially with rates as low as they are today. Some $161 billion in traditional credit is now outstanding, compared with $135 billion in home-equity lines, SMR says.
Nomenclature in the second-mortgage world is getting fuzzy, as the term “home equity” is increasingly applied to both old- and new-style loans. Differentiate this way:
Closed-end second mortgages. You borrow a fixed sum of money against your house or condominium, at a fixed interest rate for a fixed term like 10 or 15 years. Rates currently average around 9.9 percent. You also pay closing costs and points (a point is 1 percent of the loan).
Open-end second mortgages. You open a revolving line of credit against your home. To borrow money, you just write a check against the line. Bank rates typically float around 2 percentage points over the prime rate-putting them now at 8.5 percent. SMR says that finance companies may charge 4 to 6 points over prime. So don’t even consider a finance company unless two banks have turned you down. Some lenders, especially in the East and West, will open a line for low or no fees; others charge closing costs and points. Credit unions generally offer the lowest price, according to Moebs Services, which surveys the field.
For borrowers, closed-end loans offer discipline. They’re expensive to rewrite for a larger amount, which helps contain your impulse to spend. Because payments are fixed, you’re not affected when interest rates rise. By contrast, open-end lines are all rubber. They fit serial needs like regular loans for college tuition. But you must be prepared to handle the payments if interest rates rise.
Tapping into home equity raises some questions that not many borrowers consider. Lifestyle questions, like:
If you’re married, are you happy? It takes only one signature to originate a loan against a home-equity line. In two divorce cases I know of, the husband emptied the home-equity line, spent the money and didn’t repay, sticking the wife with a mammoth debt.
Will you want to move? You may find that you can’t, if your second mortgage is too big. After paying off both mortgages, there may not be enough money left over to make a down payment on another nice house.
Do you want to refinance your first mortgage at a lower rate? It gets much more expensive when a second mortgage tags along. You’ll have to refinance both loans at once, replacing them with one larger loan. That should give you a lower monthly payment, but it costs extra money in points. If you stretch out the term of your second-mortgage loan, you may pay more interest in the end.
Have you hedged your risk? Dining out on the equity in your home will not ruin your finances if you have money on the side. Somewhere you need savings, if not in your house then in CDs and mutual funds. Those savings could then serve for, say, the down payment on your next home, if your home equity comes up short.
Do you think you might lose your job? While you’re still employed, get a big home-equity line and don’t borrow against it. If the ax does fall, you can tap that line to pay current bills. The bank probably won’t know you’re in trouble as long as no defaults appear on your credit report, says Paul Getman of Regional Financial Associates in West Chester, Pa. If it learns that you’re jobless, however, it might freeze that vital credit line. So consider borrowing all of the money, all at once, and moving it to another bank.
Will you retire early? Before doing so, open a home-equity line-just in case you need the money. In retirement, your income might not be enough to get you a loan.
Are you a retiree who’s house rich but cash poor? A handful of banks around the country offer reverse-mortgage home-equity lines of credit. You borrow against the line as needed and make no repayments. The bank gets its money back when your house is sold. A senior-citizen center may know if these lines are available to you locally.
Are you making a major home improvement? A closed-end loan is the perfect choice. You fix up your house without tempting yourself to borrow for extras.
Are you consolidating debt? If you’ve run up a high credit-card bill, you’ll save money today by refinancing with a second-mortgage loan. Normally, doing so is a cardinal sin. You shouldn’t cover everyday purchases with long-term debt, because of the compounding interest charges, says Brent Goff, an assistant professor of marketing at Auburn University. But just this once, do clear the decks with a closed-end loan. Then go and sin no more.
Are you a Texan? Second mortgages aren’t allowed in Texas except for home improvements. So normally, Texans don’t invest their spare cash in home equities. For loans, they turn to 401(k) plans, life insurance and annuities, says Bryan, Texas, financial planner Janet Briaud.
Are you buying a car? Deductible second mortgages are cheaper than most auto loans. Open-ends work best. You can borrow for a series of cars without having to start each loan from scratch. To avoid excess debt, repay at a rate that wipes out the loan by the time the car is traded in.
Are you a renter? You’re being wronged. Renters can’t tax-deduct their consumer interest, while homeowners can.
Are you gypping the system? Some borrowers are pocketing the tax break without ever putting their houses at risk. Take C&S/Sovran Bank (now part of Charlotte, N.C.-based NationsBank). It offers auto loans backed by the car and your home simultaneously. The mortgage makes the loan interest tax deductible. If you can’t repay, however, the bank repossesses only the car. In Congress, debate has begun on whether, and how, to end this abuse. The loophole makers always seem to be one step ahead.
