Home Equity Loans And Lines Of Credit

Written by Steve R. Lowry    Thursday, 22 January 2009

If refinancing doesn't make sense, you have two options to consider next: home-equity loans, which are made in a lump sum and have a fixed interest rate; and home-equity lines of credit, also known as HELOCs, which you can draw on in small chunks over a period of time and have variable interest rates. Both have repayment terms of anywhere from five to 20 years, and the interest on at least the first $100,000 can be deducted from your taxes (unless you get hit by the alternative minimum tax, in which case the interest is deductible only if the loan goes toward home improvements). And compared with first mortgages, both are easy and inexpensive to set up: Home-equity loans cost about $200, while lines of credit can sometimes be had with no up-front fee. HELOCs feature especially attractive rates: 4.5% on average, compared with 7.25% for a 10-year fixed loan. Home renovations are the most common use for these loans. Richard and Linda Krieger, for example, of Oak Park, Mich., took out a $50,000 line of credit to redo their kitchen last year. "It started with new furniture in the family room, and it looked so good we decided to do the kitchen too," says Linda. "I was tired of looking at those same lousy cabinets in the kitchen after 31 years." The Kriegers used just $25,000 for remodeling. And though the current minimum payment is only $77 a month, they've wisely been paying as much as $700 a month with a goal of retiring the loan early. Many Americans use their home equity to jump-start business ventures. We wouldn't recommend that everyone bet their primary residence on the success of a small business. But for Miami residents Jen and Dinorah Yavitz, 32 and 40, it looked like a worthwhile gamble. Last fall Jen, who has run a drug-and-alcohol testing service out of his home for the past seven years, decided to buy and renovate a nearby building and use part of the extra space to expand his business. Rather than taking out a commercial loan at 12% interest, he went with a $100,000 line of credit on his primary residence at 4.5%, which currently costs him $377 a month. Once the renovation is complete, Jen plans to rent out half the space for three times the amount of his HELOC payments--and he figures it makes sense to keep the payments as low as possible until the renovation is done and the business is running. "I wouldn't be able to rent an office space for under $400 a month," he notes. Another clever use of these loans applies to those who have three years or less left on their primary mortgage. If you haven't refinanced because the $2,000-plus cost outweighs the savings you'd recoup in just a few years, you may want to pay off your mortgage with a line of credit. You'll essentially be getting a very cheap, short-term refi. So how do you decide between a loan and a line of credit? Here are some guidelines: • Go for a line of credit if you're not sure how much, or even if, you need to borrow. For continuing expenses--say, helping a child with college bills--a line of credit makes sense because you can take the money on an as-needed basis. An unused line of credit can also provide a safety net against a job loss or other emergency expenses. That said, lines of credit are considered revolving debt by credit scoring companies. If you max out your line, you'll hurt your score. Loans, on the other hand, are considered installment debt and will help your score as long as you always pay on time. • Go for a line of credit if you can repay the loan in four years or less. Because the interest rate on the average line of credit is nearly three percentage points below the rate on the average loan, you should come out ahead with a line of credit even if rates rise by one percentage point each year--and few experts think they'll go up much faster. (The converse, of course, is also true: Go with a home-equity loan if it will take you more than four years to repay.) • Choose a home-equity loan if you might not be able to resist borrowing extra. Let's face it: A line of credit that you can draw on anytime is pretty much a $25,000 wad of cash sitting in your desk drawer. You might find yourself blowing $3,000 of it on a wide-screen TV. And eager lenders have all but encouraged that kind of behavior. Some banks, including Wells Fargo, even offer a product that lets you draw on your HELOC at retailers using a charge card. "Our experience is that customers are very self-conscious about using their home equity," says Doreen Woo Ho, the president of Wells Fargo's consumer credit group. Maybe. But do you really want that kind of temptation? Here are a few more tips about home-equity loans and lines of credit: • Shop around. Home-equity loans in particular tend to be offered at widely varying interest rates by different lenders; with a little searching, you can currently find a fixed-rate loan for under 6%--not much higher than some HELOCs. • With home-equity lines of credit, pay close attention to the terms. Some lenders tack on $50 to $100 in annual fees, and some charge early-termination and inactivity fees as well. And if you're planning to draw small amounts from a line of credit, watch for minimum-withdrawal fees. • Be aware that interest rates on both lines and loans are more sensitive than rates on regular mortgages to credit scores. That can work in your favor--if your credit is excellent, you may be able to get a line of credit without paperwork--but if your score is below 700, you probably won't qualify for the best rates.

Last Updated ( Thursday, 22 January 2009 )