Use Caution with Home Equity Line of Credit

Let’s consider this scenario: A year ago, a couple takes out a home equity loan - a line of credit, really.

Since then, they have used it to pay for some major improvements to the home, such as a new roof, rewiring, etc.
Even though the two may have of credit left to draw on, should there be a reluctance to use such an equity line of credit too often?

Answer: The main question is: “How secure is your income?” If you have a steady, dependable income stream - whether it’s from a good job or your own business - and you feel confident that you won’t run into financial difficulties in the foreseeable future, there is nothing inherently wrong with using the home equity line of credit to pay off your other bills.

Your monthly expenses will be lower and the interest will be tax-deductible.

One reason for the popularity of home equity loans is the 1986 Tax Reform Act, which eliminated the tax deduction for interest on credit cards, car loans and other consumer borrowing. The interest expense on home equity loans is one of the few remaining “tax shelters” left, so many people now use tax-deductible home equity loans to purchase cars rather than nondeductible auto loans.

If you can handle the monthly payments, there’s nothing inherently wrong with that. Just remember that if you take out a car loan and you don’t make your payments, the lender will repossess your car. But if you get overextended with a home equity line of credit, the mortgage lender can foreclose on your house.

It’s sad to see a job loss or other economic calamity force people out of homes they’ve lived in for 10 or 20 years. In some cases, the added debt load from a home equity loan or cash-out refinance is the difference between keeping or losing their home.

This has not been a big problem recently thanks to the hot housing market over the last five years because appreciation can add enough value to allow homeowners to sell their house and net enough cash to pay off their debts and selling costs. But who wants to put themselves in that kind of situation?

Home equity loans were originally designed to finance home improvements. That makes sense because improvements add equity value to your home, which increases the collateral value for the loan. If you run into financial difficulties that force you to sell the home, the increased market value would hopefully cover the additional debt.

It can also make sense to use a regular or bad credit home equity loan to pay off nondeductible, high interest rate credit cards because you’re eliminating some of your monthly payments. If you use a home equity loan to purchase a car, you could always sell the car to help pay off the loan. But if you use a home equity loan to pay for a family vacation, the money is simply gone.

There is no increased equity to cover the debt if you get into financial trouble.

Another factor to consider is the interest rate risk. If you took out a home equity line of credit in 2004 when the prime rate was 4 percent, you have seen the interest rate on your line of credit more than double to 8.25 percent today.

Home equity loan rates are not likely to increase significantly during the rest of this year, but if you were not financially prepared to see your payments rise during the past three years, you could be in serious trouble.

SOURCE: The Daily Herald