A home equity line of credit can be a useful way to turn your house into cash.
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Let’s take a few moments to talk about the different choices you have when it comes to the withdrawal of the equity in your house.
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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. Read the rest of this entry »
Before you can understand the benefits of a first-lien HELOC, you probably nee to understand what this prodct entails:
A first-lien HELOC is basically a home equity line of credit (HELOC) in the first lien (or first mortgage) position. Confused? Let us explain.
Typically a home equity line of credit is considered a second mortgage. Naturally, you can’t have a second mortgage without a first. Therefore, let’s say you have a home worth $100,000 that you obtained with a traditional first mortgage.
You’ve paid off $75,000 of the principal on that mortgage and you owe $25,000 (in principal). If you got a home equity line of credit, you could use the money you get from the HELOC to pay off the first mortgage. You no longer have a first mortgage, so the HELOC then becomes your first lien.
When you make a mortgage payment, you’re paying two basic things:
Principal is the amount you borrowed in the first place and the interest is the fee charged by the mortgage lender for borrowing the money. There is an inverse relationship between how much interest you pay to how much principal you pay toward your mortgage.
In the beginning of your loan term, your mortgage payment is mostly interest and very little principal. As the loan term progresses, you pay increasingly less interest and more principal until toward the end of your loan term when your mortgage payment is mostly principal and very little interest.
Why Get a First-Lien HELOC?
Understanding all that, a first-lien HELOC can be quite useful.
Let’s say you have a traditional 30-year fixed-rate mortgage that you’ve been paying faithfully for 25 years. You may know by now that mortgage interest is usually tax-deductible.
However, now you’re in the later stages of your home mortgage loan where you’re paying very little mortgage interest, as we just explained. Therefore, trying to deduct the interest from your taxes isn’t offering any real benefits at this point.
If you were to get a home equity line of credit, you could use the HELOC to pay off your 30-year fixed and the HELOC becomes your first mortgage, or first lien. Now you’re at the beginning with your new mortgage and you can deduct more mortgage interest again.
Of course, you could also get a first-lien HELOC if you’ve paid off your house and own it outright.
Either way, now you have a mortgage that works like a credit card in that you can draw from the account at any time and pay it back if and when you draw.
Having this kind of flexibility can come in handy if you need to draw from it to make ongoing home improvements and have to pay several contractors; if you have a child who’s getting ready for college and you need to pay their tuition and other college expenses; or if you are thinking about buying that fishing boat you’ve always wanted and have to make payments on that.
Remember, it’s better to pay for these sorts of big expenses with the money from your home equity line rather than with your credit card because you get a better interest rate on the money you borrow and the interest on your mortgage is usually tax-deductible whereas the interest on your credit card is not.
Moreover, HELOCs are tied to short-term adjustable rates which are usually lower than long-term fixed rates, so you could be getting a very good rate on a first-lien HELOC.
First-lien HELOCs provide homeowners with flexibility, liquidity, great tax advantages and a low interest rate. You can make large purchases without paying high interest rates (compared to credit cards) on the money you borrow. It may be a very good time to get a first-lien HELOC because the Federal Reserve has now kept short-term adjustable rates at the same level for the last four meetings and some experts believe they may even lower them in early 2007.
If you’re not sure whether a first-lien HELOC is right for you, contact a reputable home equity loan lender.
As a financial advisor, Don Taylor deals with many mortgage-related questions. Here’s a recent one:
Q: I currently owe $137,000 on a first mortgage at 6 percent and am considering a HELOC for home improvements. Most banks are offering interest-only mortgage products. I’m wondering if this is a good choice or should I refinance the current mortgage to get cash out at 25 years.
A: Although home equity lines of credit, or HELOCs, have interest-only payments in the early years of the loan, you can still make additional principal payments on the loan to pay down the outstanding balance. The loan is likely to have a prepayment penalty for paying off the line too rapidly, but small amounts aren’t likely to trigger this.
The good thing about the HELOC is that you don’t have to borrow the whole amount at closing. You can draw on the line as you need it, although it usually requires a draw at closing.
If you’re spending all the money in a short time span on home improvements, then a home equity loan may be the better choice. It will have a fixed rate and the monthly payments are self-amortizing, meaning the loan will be paid off with the last loan payment.
A cash-out refinancing will give you the money upfront, but you’re not likely to improve on your current 6 percent mortgage. The refi will also come equipped with much higher closing costs than the home equity line or loan.
The amount of closing costs and how long you plan to be in this home both weigh heavily on your choice of financing these home improvements.
If you’ve racked up a lot of of credit card debt — to the point that it has become difficult to make the minimum monthly payments — should you consider the use of home equity to bail yourself out? What are the tax consequences if you refinance your mortgage to utilize your equity to pay down our debts?
According to the finance columnist in the Monterey County Herald, if you utilize your home equity to consolidate debt, you may be able to wipe out those multiple nagging credit card payments, simplify your finances and lower your monthly debt expenses.
In most cases you can deduct the mortgage interest payment, which you can’t do with the interest you pay on car loans, credit cards, and private or personal loans.
There are several ways to convert the equity you have accumulated in your home to cash, including mortgage refinancing.
You may also be able to quickly tap into your equity by obtaining a 2nd mortgage or a home equity line of credit.
By refinancing, you are effectively turning the value of your home into working capital to consolidate your debts and improve bad credit. You are left with a single payment to your bank or your mortgage company that could offer better terms and a lower interest rate than your credit card obligations and other debts.
This type of mortgage loan often is referred to as a cash-out refinance or “cash-out refi.” For example, if your home is valued at $300,000 and your balance is $150,000, you might qualify for a 75 percent loan of $225,000 or more. That would allow you to repay the existing $150,000 balance and use the remaining $75,000 to eliminate other obligations.
If you choose the “cash-out” refinance option for consolidating your debts, compare the home equity loan rates and carefully evaluate your new loan terms and the tax consequences of refinancing.
When calculating the terms of your new loan against the outstanding debt obligations that you want to pay off, compare the interest rates.
Credit card interest rates often exceed 10 percent. New credit cards that promise lower interest rates may be offered at teaser rates that go up sharply in a short period of time. For example, if you paid off $25,000 in credit card debt with an APR of 13.99 percent with a cash-out refinanced loan of 7 percent, you would save approximately $1,300 a year.
Depending on how much you want to pull out from a “cash-out” refinancing, you may end up with a bigger loan and a higher monthly payment for which you must qualify. Still, refinancing usually guarantees a lower interest rate than most second or home equity loans.
When you refinance your home to pay off higher interest rate credit card debts, consider that you are trading off short-term obligations for long-term debt. While the payment is less because of the lower mortgage rates, it is amortized over 30 years.
Also, some lenders may be willing to offer you a bigger loan than necessary to pay off your obligations, and you may find yourself deeper in debt. Remember that you cannot borrow your way out of debt. A debt consolidation loan does not necessarily reduce the amount you owe. Instead, it will extend your debt further into the future.
Moreover, it may be tempting to max out your credit cards again after you have paid them off. If your purpose is to get out from under debt, put your credit cards away or at least formulate a disciplined plan for using them, such as paying off any credit charges every month.
The advantage of mortgage debt over other loans is that you cannot deduct interest paid on car loans, credit cards and personal loans. However, your home mortgage interest is only tax deductible if your loan is a secured debt in which you sign an instrument such as a mortgage, deed of trust or land contract.
Also, there is a ceiling of $1 million in mortgage debt when calculating deductible interest. The IRS expects to know how you are using cash-out refinance funds but does not preclude you from using the proceeds to pay off other debts. However, the amount cannot exceed 100 percent of your home’s value.
There are other factors that may affect the deductibility of your mortgage interest, including your original debt, the utilization of your cash-out proceeds and the basis of your home.
Stop, look and check your math before you decide to reduce your debt by tapping the equity in your home through a loan or a home equity line of credit. Weigh all your options. Think through the reasons for consolidating your debt. Is it to bring some discipline to your spending habits, simplify your debts or is it a way to reduce your monthly expenses?
Don’t forget to check with your adviser to determine your eligibility to write off the interest with the new mortgage, as well as the points and other costs that must be paid.
What’s the difference between a home equity loan and a home equity line of credit?
It’s a good, important question. With the help of Don Taylor, a certified financial advisor, allow us to provide the answer:
A home equity loan comes equipped with a fixed interest rate, along with monthly payments sized to pay off the loan over its term. You receive the entire loan amount as a lump sum when you close on it.
In contrast, a home equity line of credit (HELOC), is an adjustable-rate loan, with changes in the interest rate typically tied to changes in the prime rate, which is itself tied to changes in the targeted federal funds rate. The Federal Reserve Board’s Open Market Committee meets eight times per year to discuss the economy and decide whether to change this targeted federal funds rate.
Other differences: Besides possessing a variable interest rate, a HELOC has interest-only payments, at least in the early years of the loan. Some HELOCs are structured to have interest-only payments over the entire loan term, with a balloon payment at the end of the loan. Other HELOCs become self-amortizing loans after an initial period of interest-only payments.
It varies.
Because this is a line of credit, you only borrow what you need, although there may be a minimum draw against the line when you close on the loan. At least for part of the loan term, the credit line is a revolving credit; paying down the balance frees up credit capacity.
The changes in the federal funds rate over the past 2½ years have caused the interest rates on HELOCs to rise above the fixed rate of a home equity loan. Of course, this doesn’t mean that the loan is necessarily the better choice.
What do you plan on doing with the money? How will you manage the monthly payments? Where will interest rates be headed in the future? These are important questions to consider as you weigh various home loan options.
